Highlights from Johnson's Paper

I have tried to parse out what I thought was interesting from the paper posted below:

There were, of course, some facilitating factors behind the crisis.  Top investment bankers and government officials like to lay the blame on low U.S. interest rates after the dotcom bust, or even better – for them – the flow of savings out of China.  Some on the right of the spectrum like to complain about Fannie Mae or Freddie Mac, or even about longer-standing efforts to promote broader home ownership.  And, of course, it is axiomatic to everyone that the regulators responsible for “safety and soundness” were fast asleep at the wheel. 

But these various policies - lightweight regulation, cheap money, the unwritten Chinese-American economic alliance, the promotion of homeownership - had something in common, even though some are traditionally associated with Democrats and some with Republicans: they all benefited the financial sector. The underlying problem was that policy changes that might have limited the ability of the financial sector to make money - such as Brooksley Born's attempts at the Commodity Futures Trading Commission to regulate over-the-counter derivatives such as credit default swaps - were ignored or swept aside. 

Comparing the US to the corrupt emerging market economies:

And they were captured (or completely persuaded) by exactly the sort of elite that dominates an emerging market.  When a country like Indonesia or Korea or Russia grows, some people become rich and more powerful.  They engage in some activities that are sensible for the broader economy, but they also load up on risk.  They are masters of their mini-universe and they reckon that there is a good chance their political connections will allow them to “put” back to the government any substantial problems that arise. In Thailand, Malaysia, and Indonesia prior to 1997, the business elite was closely interwoven with the government; and for many of the oligarchs, the calculation proved correct – in their time of need, public assistance was forthcoming.  This is a standard way to think about middle income or low income countries.  And there are plenty of Americans who are also comfortable with this as a way of describing how some West European countries operate.  Unfortunately, this is also essentially how the U.S. operates today.

Wallstreet represents the financial oligarchs of the US:

Instead, the American financial industry gained political power by amassing a kind of cultural capital – a belief system. Once, perhaps, what was good for General Motors was good for the United States. In the last decade, the attitude took hold in the U.S. that what was good for Big Finance on Wall Street was good for the United States. The banking and securities industry has become one of the top contributors to political campaigns, but at the peak of its influence it did not have to buy favors the way, for example, the tobacco companies or military contractors might have to. Instead, it benefited from the fact that Washington insiders already believed that large financial institutions and free-flowing capital markets were critical to America's position in the world. 

The revolving door between DC and NYC:

One channel of influence was, of course, the flow of individuals between Wall Street and Washington. Robert Rubin, co-chairman of Goldman Sachs, served in Washington as Treasury Secretary under President Clinton, and later became chairman of the executive committee of Citigroup. Henry Paulson, CEO of Goldman Sachs during the long boom, became Treasury Secretary under President George W. Bush. John Snow, an earlier Bush Treasury Secretary, left to become chairman of Cerberus Capital Management, a large private equity firm that also counts Vice President Dan Quayle among its executives. President George H. W. Bush has been an advisor to the Carlyle Group, another major private equity firm. Alan Greenspan, after the Federal Reserve, became a consultant to PIMCO, perhaps the biggest player on international bond markets. 

Analysis of all of the bailouts:

First, there was the prominent place of policy by deal: when a major financial institution, got into trouble, the Treasury Department and the Federal Reserve would engineer a bailout over the weekend and announce that everything was fine on Monday. In March 2008, there was the sale of Bear Stearns to JPMorgan Chase, which looked to many like a gift to JPMorgan. The deal was brokered by the Federal Reserve Bank of New York - which includes Jamie Dimon, CEO of JPMorgan, on its board of directors. In September, there were the takeover of Fannie Mae and Freddie Mac, the sale of Merrill Lynch to Bank of America, the decision to let Lehman fail, the destructive bailout of AIG, the takeover and immediate sale of Washington Mutual to JPMorgan, and the bidding war between Citigroup and Wells Fargo over the failing Wachovia - all of which were brokered by the government. In October, there was the recapitalization of nine large banks on the same day behind closed doors in Washington. This was followed by additional bailouts for Citigroup, AIG, Bank of America, and Citigroup (again).  

In each case, the Treasury Department and the Fed did not act according to any legislated or even announced principles, but simply worked out a deal and claimed that it was the best that could be done under the circumstances. This was late-night, back-room dealing, pure and simple. What is more telling, though, is the extreme care the government has taken not to upset the interests of the financial institutions themselves, or even to question the basic outlines of the system that got us here. 

On the hidden subsidies given to the banks (to complex for the general public to understand):

As the crisis deepened and financial institutions needed more assistance, the government got more and more creative in figuring out ways to provide subsidies that were too complex for the general public to understand. The first AIG bailout, which was on relatively good terms for the taxpayer, was renegotiated to make it even more friendly to AIG. The second Citigroup and Bank of America bailouts included complex asset guarantees that essentially provided nontransparent insurance to those banks at well below-market rates. The third Citigroup bailout, in late February 2009, converted preferred stock to common stock at a conversion price that was significantly higher than the market price - a subsidy that probably even most Wall Street Journal readers would miss on first reading. And the convertible preferred shares that will be provided under the new Financial Stability Plan give the conversion option to the bank in question, not the government - basically giving the bank a valuable option for free.  

Obama isn't doing shit either:

This continued solicitousness for the financial sector might be surprising coming from the Obama Administration, which has otherwise not been hesitant to take action. The $800 billion fiscal stimulus plan was watered down by the need to bring three Republican senators on board and ended up smaller than many hoped for, yet still counts as a major achievement under our political system. And in other ways, the new administration has pursued a progressive agenda, for example in signing the Lilly Ledbetter law making it easier for women to sue for discrimination in pay and moving to significantly increase the transparency of government in general (but not vis-à-vis its dealings with the financial sector).  

What it shows, however, is that the power of the financial sector goes far beyond a single set of people, a single administration, or a single political party. It is based not on a few personal connections, but on an ideology according to which the interests of Big Finance and the interests of the American people are naturally aligned - an ideology that assumes the private sector is always best, simply because it is the private sector, and hence the government should never tell the private sector what to do, but should only ask nicely, and maybe provide some financial handouts to keep the private sector alive. To those who live outside the Treasury-Wall Street corridor, this ideology is increasingly not only at odds with reality, but actually dangerous to the economy.

How to clean up the balance sheets of these banks:

Cleaning up bank balance sheets cannot be done through negotiation. Everything depends on the price the government pays for those assets, and the banks’ incentive is to hold up the government for as high a price as possible. Instead, the government should thoroughly inspect the banks' balance sheets and determine which cannot survive a severe recession (the current “stress tests” are fine in principle but not tough enough in practice). These banks would then face a choice: write down your assets to their true value and raise private capital within thirty days, or be taken over by the government.  The government would clean them up by writing down the banks' toxic assets - recognizing reality, that is - and transferring those to a separate government entity, which would attempt to salvage whatever value is possible for the taxpayer (as the Resolution Trust Corporation did after the Savings and Loan debacle of the 1980s).

Break up to financial oligarchy: no more too-big-to-fail institutions:

In the U.S., this means breaking up the oversized institutions that have a disproportionate influence on public policy. And it means splitting a single interest group into competing sub-groups with different interests. How do we do this? First, bank recapitalization - if implemented right - can use private equity interests against the powerful large bank insiders.  The banks should be sold as going concerns and desperately need new powerful shareholders.  There is a considerable amount of wealth “on the sidelines” at present, and this can be enticed into what would essentially be reprivatization deals.  And there are plenty of people with experience turning around companies who can be brought in to shake up the banks.  The taxpayer obviously needs to keep considerable upside in these deals, and there are ways to structure this appropriately without undermining the incentives of new controlling shareholders.  But the key is to split the oligarchy and set the private equity part onto sorting out the large banks.  

The second step is somewhat harder. You need to force the new private equity owners of banks to break them up, so they are no longer too big to fail – and making it harder for the new oligarchs to blackmail the government down the road. The major banks we have today draw much of their power from being too big to fail, and they could become even more dangerous when run by competent private equity managers.

Ideally, big banks should be sold in medium-sized pieces, divided regionally or by type of business, to avoid such a concentration of power. If this is practically infeasible – particularly as we want to sell the banks quickly – they could be sold whole, but with the requirement of being broken up within a short period of time. Banks that remain in private hands should also be subject to size limitations. 

This may seem like a crude and arbitrary step, but it is the most direct way to limit the power of individual institutions, especially in a sector that, the last year has taught us, is even more critical to the economy as a whole than anyone had imagined.  Of course, some will complain about “efficiency costs” from breaking up banks, and they may have a point.  But you need to weigh any such costs against the benefits of no longer having banks that are too big to fail.  Anything that is “too big to fail” is now “too big to exist.” 

To back this up, we quickly need to overhaul our anti-trust framework.  Laws that were put in place over 100 years ago, to combat industrial monopolies, need to be reinterpreted (and modernized) to prevent the development of financial concentrations that are too big to fail.  The issue in the financial sector today is not about having enough market share to influence prices, it is about one firm or a small set of interconnected firms being big enough so that their self-destruction can bring down the economy. The Obama Administration’s fiscal stimulus invokes FDR, but we need at least equal weight on Teddy Roosevelt-style trust-busting. 

Put caps on Wall Street's compensation:

Third, to delay or deter the emergence of a new oligarchy, we must go further: caps on executive compensation - for all banks that receive any form of government assistance, including from the Federal Reserve - can play a role in restoring the political balance of power. While some of the current impetus behind these caps comes from old-fashioned populism, it is true that the main attraction of Wall Street - to the people who work there, to the members of the media who spread its glory, and to the politicians and bureaucrats who were only too happy to bask in that reflected glory - was the astounding amount of money that could be made. To some extent, limiting that amount of money would reduce the allure of the financial sector and make it more like any other industry. 

 Everyone should read the whole paper, and also read Johnson's article that came out in the Atlantic the past month on the same topic: