How the Fed Created the Post-2008 Global Safety Net for Banks

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Yves here. This article introduces a wonderfully colorful and information-rich paper by the late Ed Kane that not only discusses how large and interconnected the effects of the Fed’s bank subsidies were, but also excoriates how dishonestly they were presented. They represented massive support to banks, with virtually nothing asked of them in return, while the Fed and Treasury made nearly all struggling mortgage borrowers go pound sand. It can’t be said often enough that the bailouts were transfers from ordinary people to the wealthy.

To entice you to read the paper proper, one short section:

To justify these actions, Geithner boldly claims that “not imposing losses or haircuts on nondeposit unsecured and secured claims on banks …helped stabilize the financial system at much lower cost and recapitalized it with private, rather than public money” (Geithner, 2016, p. 24). The last 13 words of this passage have no foundation and make my blood boil. At “lower cost” to whom and compared to any and all alternatives? Because it does not define what he means by “cost” or specify a concrete alternative, the statement has no provable economic content. Then he goes on to mischaracterize the nature of the recapitalization that occurred at megabanks. Figure 6.1 shows that plenty of public money was used before private funding was restored.

This leads me to ask why an industry would heap adulation on so lame a spokesperson. My answer is that the praise is simultaneously a payoff for past services and an investment in rebuilding the industry’s clout with future regulators. The undeserved accolades serve as a not-so-subtle way of undermining the hard-nosed approach to future insolvency resolution envisioned in the Dodd-Frank Act. Industry leaders must hope that persuading the press to treat this generation of crisis managers as conquering heroes will establish a cultural precedent strong enough to force their successors–without much hesitation—to carry forward the elitist priorities the troika adopted during the GFC into future rounds of crisis.

And another:

Waves of bad conduct resemble crime waves. They make us wonder whether our bank may be ripping us off, too. Such headlines not only undercut our confidence in the ethics of the finance professionals, they shift the burden of assuring honest conduct onto the supervisory system. However, at the same time, the infrequency with which corporate punishments are accompanied by punishments for the individual managers who orchestrated the misconduct further weakens everyone’s faith in the justice system. Although headlines show that supervisory systems have not totally failed us, the lack of individual punishments indicate a distressing lack of teeth. The critical role that third-party supervision and back-up play in maintaining confidence in modern financial systems is what makes legislators’ and regulators’ resort to bullsh*t so dangerous. Policies that make bad behavior seem okay force those who execute these policies to act in concert with the bad guys whose behavior they cover up.

Any parent understands this. Children routinely try to hide questionable behavior from their parents. Parents who turn a blind eye to a child’s deceit reinforce two harmful ideas. The first is that the child is the smartest person in the room. The second is that adults do not understand why the child finds unruly behavior so satisfying

By Edward J. Kane, Professor of Finance, Boston College. Originally published at the Institute for New Economic Thinking website

Edward J. Kane died before he could finish a final book. But he had completed several chapters. Of course, he did not have a chance to revise or correct the manuscripts, though he worked several over repeatedly. We believe this one’s treatment of the roots of Federal Reserve programs that are, in effect, subsidies to financial institutions is brilliantly conceived and well-argued. We are, therefore, with the permission of the family, now issuing it as an INET Working Paper.

Its message can be summarized simply, using some language lightly adapted from the paper itself.

Despite Fed officials’ growing willingness to tell us about FOMC meetings and the interest-rate and price-level targets they generate, forms of Fed policymaking that have questionable distributional effects still take place in curtained areas. For example, one can find information on the Fed’s many separate bank rescue programs on Fed websites. However, a careful analysis of cross-program subsidized lending to giant US and foreign banks during the GFC (whose size is summarized in this INET Working Paper, Figure 6.1) is sorely needed. Taxpayers deserve to know not only the magnitude of particular credit flows but also the flow of day-by-day subsidies buried in the “liquidity” support that the Fed provided. To the best of my knowledge, a breakdown of the subsidy flow has never appeared in a Federal Reserve press release or special report.

The value and anti-egalitarian character of subsidized support deserve analysis because, until the opportunity costs and adverse distributional character of Fed policies are compiled and presented honestly to the electorate, industry praise for this support should be viewed with a skeptical eye.

To my eye, Fed programs appear to have required ordinary US citizens to subsidize their much richer counterparts. If so, this would explain why mega-bankers around the world might unite: (1) to promote the idea that what was transferred was only “liquidity,” and (2) to praise the troika of Geithner, Paulson, and Bernanke so lavishly.

These three individuals are lucky that no one is out there organizing counter rallies against them. Themes for such protests would stress that these men: (1) supplied bailout funds to uninsured creditors of firms and governments that were economically insolvent, (2) supplied these funds at unnecessarily below-market terms, (3) imposed no losses or “haircuts” on rescued positions, and (4) failed to recognize and avert the buildup of crisis pressures before things became bad enough to pose a threat to the system. The troika’s policy strategy prevented open insolvencies at US megabanks by making subsidized Fed loans to US megabanks’ foreign counterparties (and to the foreign taxpayers that would otherwise have been asked to rescue them). At the same time, they resisted a broad-based bailout of insolvent US homeowners. They stood by as US banks foreclosed on all but a few privileged categories of distressed household mortgage borrowers. Had these officials wished, they could have established parallel programs of equally comprehensive assistance for over-mortgaged US households. But they understood that the distributional controversy over openly subsidizing one set of US citizens at the expense of another might have torn our political system apart. The irony is that the troika found it easier to rescue rich foreigners than impoverished US families.