When the Rain Came Down
A masterful account of how the housing crisis and credit crunch nearly brought down the economy
Alan S. Blinder is one of America's leading economists. One of the few economists who write really well, he is also a master storyteller. In "After the Music Stopped," Mr. Blinder, previously a vice chairman of the Federal Reserve Board and, before that, a member of President Clinton's Council of Economic Advisers, gives his interpretation of the events leading to the U.S. financial crisis, the financial crisis itself, and the Bush and Obama administrations' response. It is one of the best books yet about the financial crisis.
After the Music StoppedBy Alan S. Blinder
The Penguin Press, 476 pages, $29.95
Let's begin with the most important of the relatively uncontroversial points that Mr. Blinder makes about the financial crisis. It began with the housing price bubble between 1997 and 2006 and the subsequent collapse of housing prices over the next few years. A major cause of the bubble was that many mortgage lenders lent to people whom anyone with common sense would have seen to be really bad risks. In addition, mortgages had been sliced, diced and repackaged into securities, so that a given person's mortgage was not held by one individual or one firm, making it hard for borrower and lender to come to terms after the house's value fell. Finally, the credit-rating agencies failed spectacularly to do their job. Had the three major firms that rate bonds—Standard & Poor's, Moody's MCO +0.28% and Fitch—assessed various mortgage-backed securities accurately, many bond buyers would have been prepared for the risks they were taking and some would not have bought the bonds at all. These facts are all pretty much agreed on, and Mr. Blinder does an excellent job of laying them out in the first third of his book.
A somewhat more controversial claim Mr. Blinder makes (but one I agree with) is that the turning point in the financial crisis was the federal government's refusal, in September 2008, to bail out Lehman Brothers. "The Lehman decision," writes Mr. Blinder, "abruptly and surprisingly tore the perceived rulebook into pieces and tossed it out the window." Now market participants began to think that the federal government would let large financial firms fail. Mr. Blinder sees this as so important a turning point that he refers frequently to Sept. 15, the day Lehman filed for bankruptcy, as "Lehman Day." Had the feds bailed out Lehman, he argues, the panic that hit Wall Street would have been less extreme.
But Mr. Blinder omits a crucial fact about Lehman, one that, by itself, explains why the huge drop in value of Lehman's mortgage-backed securities led to its collapse: the effect of changes in federal bankruptcy law. Thanks to the 2005 Bankruptcy Abuse Prevention and Consumer Protection Act, when Lehman went bankrupt it could not simply, as in earlier days, pay holders of derivatives as much as possible with its assets. Instead, it had to give each derivative holder a new contract identical to the one it had signed with Lehman, but with a different counterparty. Lehman would also have to pay the transaction cost of the new contract. Such costs are typically about 0.15% of the contract's total value. That's small, right? No. When Lehman went bankrupt, the face value of Lehman's derivative contracts was $35 trillion—with a "t." The transaction costs alone were $52.5 billion. That is what sank Lehman.
Mr. Blinder also points out that Reserve Primary Fund, the "world's oldest money market mutual fund," had 1.2% of its assets invested in commercial paper—that is, short-term bonds—issued by Lehman. With the value of Lehman's bonds falling after it went bankrupt, Reserve Primary Fund had to "break the buck." Until then, most people thought that the value of each share in a money-market fund (MMF) would always be $1. Depositors thought that if they had, say, 1,000 shares in the fund, they could redeem them for $1,000. Yet the value could actually fall if the underlying assets lost enough value.
When depositors tried to withdraw their funds, Reserve started paying them 97 cents for shares that depositors expected to be worth $1—thus "breaking the buck." Investors in other money-market funds, fearing something similar, started redeeming their shares. In just one week in late September, depositors withdrew $350 billion from MMFs. As other MMFs sold commercial paper to generate the funds to redeem their customers' shares, the value of commercial paper fell further. One Federal Reserve economist quoted by Mr. Blinder recalled that "we were staring into the abyss" and "there wasn't a bottom to this." That led Treasury Secretary Henry Paulson to get President Bush's permission to set up insurance for MMF depositors. It worked, and the outflow from MMFs stopped.
This bailout, according to Mr. Blinder, was "sorely needed" to stem the fire sale of commercial paper. But that's highly debatable. Had the Treasury made clear that it would not bail out MMFs, then many of them would have also had to "break the buck." Once depositors knew there was no gain from getting their funds out early, the run on MMFs would have ended, thus stopping, or dramatically slowing, the plunge in value of commercial paper.
Mr. Blinder is a strong believer in the ability of government regulation to solve problems and even prevent them in the first place. He sees the private sector as mainly to blame for the housing and financial crises and criticizes "laissez-faire" economic policies adopted by the Clinton and Bush administrations that supposedly contributed. But I do not think that term means what he thinks it means. Laissez-faire has traditionally meant that the government keeps its hands off the economy and allows for economic freedom. But at times, Mr. Blinder applies the term to cases in which the government, once its hands were already all over the economy, didn't take the additional steps he favored.
At other times he does use the term in its traditional sense but fails to establish that it applies. Consider, for example, three major forms of government intervention that helped cause the housing bubble: (1) the Federal National Mortgage Association FNMA -0.72% (Fannie Mae) and the Federal Home Loan Mortgage Corp. FMCC -0.69% (Freddie Mac); (2) the 1977 Community Reinvestment Act, which requires banks to lend mortgage money to people who are bad risks; and (3) federal deposit insurance. During the years when the housing bubble developed, Fannie Mae and Freddie Mac contributed by relaxing their mortgage lending standards so that they were buying subprime mortgage-backed securities (MBS). Mr. Blinder himself notes that, by 2004, Fannie and Freddie owned a third of all subprime MBS. This figure was down to 17% by the summer of 2007, but, as Mr. Blinder admits, 17% is still a large number.
Part of the reason for the size of these holdings, Mr. Blinder notes, is that Fannie and Freddie were pressured by the "affordable housing goals" of the Department of Housing and Urban Development. Interestingly, although the Community Reinvestment Act, whose enforcement Mr. Blinder's previous boss, President Clinton, beefed up in 1995, was part of the "affordable housing goals," Mr. Blinder never names that legislation. In any case, this does not sound like laissez-faire.
Finally, consider the role of deposit insurance. By insuring 100% of bank deposits up to $100,000 (and, later, $250,000), the federal government substantially weakened depositors' incentives to monitor their banks' lending practices. Even Franklin D. Roosevelt, whose administration introduced deposit insurance in 1933, spoke eloquently of this downside. And the $250,000 limit, moreover, is not really a firm cap. Wealthy people can legally avoid it with the help of firms such as Promontory Interfinancial Network, which divide deposits held in one bank into smaller deposits in many banks. Mr. Blinder well knows this; as he reveals in a footnote, he is a part owner of Promontory. Again, this is not laissez-faire. Banking is one of the most heavily regulated industries in the United States.
None of this is to say that the financial crisis would not have happened without these three interventions. The private sector had a large role, and unjustified optimism is not limited to the government sector. It is to say, though, that the financial crisis would not have been as bad had the government been truly laissez-faire.
So once the financial crisis happened, what was to be done? Mr. Blinder devotes the bulk of his book to the immediate response to the crisis as well as to ways for avoiding a repeat. He praises the Troubled Asset Relief Program and points out that the net cost of TARP to taxpayers is not the $700 billion that was budgeted for but, rather, a much more modest $32 billion. But there was another way to go, the way Alan Greenspan handled the 1987 stock market crash, the Y2K episode in 1999 and 2000, and the post-9/11 economy. That way was to have the Fed purchase Treasury bills through open-market operations to make sure the economy had ample liquidity. In all three cases, it worked.
Many people think that that's exactly what Federal Reserve Chairman Ben Bernanke did when the crisis hit, but he did not. Mr. Blinder, to his credit, recognizes this, pointing out that, although the Fed changed its composition of assets, it had little effect on the money supply. He makes this point briefly, but in a 2011 article San Jose State University economist Jeffrey R. Hummel provides chapter and verse, noting that Mr. Bernanke took on extensive discretionary power to favor some financial assets over others. As Mr. Hummel puts it, under Mr. Bernanke "central banking has become the new central planning." Mr. Blinder seems to sense this but, unfortunately, does not pursue the point.
Mr. Blinder is a Keynesian, that is, someone who believes that the federal government should use fiscal policy—changing taxes and government spending—to stabilize the aggregate demand for goods and services. He therefore favored the stimulus policy that President Obama adopted his second month in office. Mr. Obama had the government increase spending in order to create more demand for goods. But Mr. Blinder is relatively unconcerned about whether the money was spent on valuable items. He has what I call the "GDP fetish"—the belief that increases in GDP are good whether or not they represent increased production of things that people actually value. If the government spends $100 billion digging holes and then filling them back up, then GDP can rise by $100 billion or more even if the $100 billion is totally wasted. Some stimulus projects, in fact, are little better than hole-digging. One example I noted on a recent visit to Detroit is the tearing up of sidewalk corners to make them wheelchair-friendly, even though the sidewalks themselves have so many craters that people in wheelchairs use the roads instead. With his faith in government intervention, Mr. Blinder sees the corners but not the craters.
—Mr. Henderson is a research fellow with the Hoover Institution and
an economics professor at the
Naval Postgraduate School in Monterey, Calif.