Policy Session 4: Government Absorption of Financial Risks during Crisis and Closing Remarks
This session discussed the contemporaneous economic costs of government guarantees and bailouts and considered the extent, costs, and benefits of current guarantees. Minnesota Fed first vice president Ron Feldman moderated the conversation with panelists Deborah Lucas, Sloan Distinguished Professor of Finance and director of the Golub Center for Finance and Policy at MIT, Boston College finance professor Phil Strahan, and Kevin Warsh, Shepard Family Distinguished Visiting Fellow in Economics at the Hoover Institution and lecturer at the Stanford Graduate School of Business. Atlanta Fed executive vice president and director of research Paula Tkac closed the conference with a look back at 30 years of the FMC and a special tribute to Atlanta Fed economist emeritus Larry Wall.
Transcript
Ron Feldman: Welcome, everybody. I guess the way to start is to say, "Good afternoon." Awesome. Very well-trained audience after a couple of days. I'm Ron Feldman from the Federal Reserve Bank of Minneapolis. I'm not planning on saying anything that much, but in case I do happen to say anything, those are clearly my own views and they're nobody else's views. I want to thank the Atlanta Fed, like everyone else has done, for putting on a great conference, in a great location, interesting topics, very well organized.
I want to maybe give them particular thanks for two areas of underappreciation. This topic that we're going to cover today, thinking about the contingent liabilities of the federal government, is, in my humble estimation, wildly underappreciated. It's a big topic, and we've got really stellar panelists who are some of the experts in this area. Thank you for doing that. I also think there's been underappreciation of the role of the moderator. I think the moderator in all these panels have been excellent. In typical Federal Reserve fashion, there's no coordination. They're doing whatever they want. I appreciate that.
I'll do two quick things. First, I'll do a very, very brief introduction of the panelists. Their bios, you have them, they're very accomplished. They're all holding chairs of some sort. Someone gave a lot of money, and so let's repeat those names out there to encourage them to give more money. We've got Debbie Lucas, who will be doing the paper. Debbie is the Sloan Distinguished Professor of Finance at the MIT Sloan School of Management, as well as being the director of the Golub Center for Finance and Policy.
We've got commenters on the paper. We've got Phil Strahan, from the Carroll School of Management at Boston College, where he's the John L. Collins, SJ Chair in Finance, and Kevin Warsh, who is the Shepard Family Distinguished Visiting Fellow in Economics at the Hoover Institution. In addition to their accomplishments, they've all been dedicated public servants in different capacities. Thank them for doing that.
The other thing I wanted to do, just to set up, is to ask, what are the key questions? This is not a group that's been shy in asking questions, but I just want to lay out what I think are the key questions that I hope will be addressed here. The first sounds like it doesn't need to be asked, but should we be measuring these contingent liabilities, both the explicit liabilities and the implied liabilities, of the federal government?
This is mostly a group of economists, policy analysts, investors, so it would seem crazy to say, should we measure that? Of course, we should. The fact that we don't do it very often, and we often do it very poorly implies that somebody someplace thinks that we shouldn't be measuring these things. That's not quite as obvious a question as it sounds.
Once we decide we do want to measure it, how should we measure it? There's lots of ways. Third, to what use? Is it a footnote? Is that how this should be showing up? Should it be showing up in the accounting of the US government? Should it be showing up in the budget of the US government? How should people use this information? Finally, how should it inform policy choices that policymakers have to make? Those are related, but they're not all quite the same thing. With that, I will turn it over to Debbie.
Deborah Lucas: I want to start by also thanking the organizers. I can't imagine a happier circumstance than being invited to come to a place with armadillos on the lawns, and waves crashing outside my windows, and getting to talk about bailouts and guarantees to this audience. This is a good day for me.
Let me start out by just talking. The broad background of all of this is governments are taking on an increasingly large share of the credit risk in economies all over the world, including in the US. Just to give you a flavor for what's going on in the US, the graph I have there is looking at the growth of traditional US credit programs from about 1970 to the present. The biggest components of those traditional programs are student loans and FHA and other mortgage guarantees.
There's SBA loans, and actually there's a hundred little credit programs in there. You can see that just in terms of the outstanding credit that's either directly lent or guaranteed it went up significantly, both during the Global Financial Crisis, and again during COVID. Those traditional programs now have about $5 trillion in outstanding credit exposure for the US government. If you throw in all the other contingent liabilities that are significant, Fannie and Freddie, in other words, the majority of the US mortgage market, deposit insurance, PBGC insurance (pension insurance), it all comes out to being more than $20 trillion where the US takes a significant amount of the credit risk and especially the tail risk.
Although we are supposedly a capitalist country, I would say these kinds of credit programs are more prevalent in the US than they are in other advanced economies. Nevertheless, other governments also have a giant footprint in their credit markets. This is just from recent work I did with a coauthor at the IMF, Gee Hee Hong, on the credit programs that were invented and rolled out during COVID to create support. This is looking at seven advanced economies, I guess the headline numbers are—this is a statistic from the IMF— they measured that the so-called credit envelope in advanced economies, that is the amount of credit that these countries made available, mostly to fund small business and medium-sized business loans, also a little bit for households, and they made available about 11 percent of GDP, which is on exactly the same order of magnitude as traditional fiscal assistance, which we know came out in great quantity during COVID. I'm going to talk more about the GFC and the COVID programs, but what I want to do is start out by talking a bit about what Ron queued up, which was the imperative to measure costs.
As Ron alluded to, what governments do now with regard to measuring the cost of contingent liabilities, is practically nothing. I'll refrain from getting into the nitty gritty of the details of "practically nothing." I will say that a lot of times, because various kinds of credit support falls outside of normal accounting and budgetary practices, particularly budgetary practices, it's essentially invisible, in terms of both the cost and the risk.
Part of the problem with bringing it into government accounting is that government accounting is more or less always on a cash basis, and you really can't account for these contingent liabilities on a cash basis and have a clear picture of what exactly you're doing. As Peter Fisher famously said, the US is a large insurance company with a side business in national defense, and an insurance company that does its accounting on a cash basis is a disaster waiting to happen. I've always loved that quote.
You have this cash-based accounting, and to the extent that some governments, including our own, do use some accrual accounting for this, they tend to use government discount rates, and that really understates the cost of those obligations. Why does this matter? I think it matters enormously. The thing about these contingent liabilities is they are "tail event" contingencies, so it's really rare that policymakers are punished for bad outcomes because we hardly ever see bad outcomes. After the GFC, basically, things recovered and so forth. I'll talk more about that later.
I would also say that I think in this group it's a little bit speaking to the choir, for the most part, to say that we really don't want a lot of bailouts and a lot of guarantees. Just saying that they're bad as a practical matter isn't enough, because anything that's free does get overused, and if they are not budgeted for they appear free. I guess to answer one of Ron's questions, I'll say it's the budget where they really need to be first and foremost and we want to report about it in other places, too.
Arguably, policymakers are over-relying on guarantees, in part because their costs are hidden. It's creating a buildup of risk exposure. There was a lot of conversation, even at this conference, about fiscal capacity, fiscal cliffs. Certainly, whatever we're building up to in terms of underfunded social security and Medicare and everything else, we also have these contingencies, and it's contributing to that. Clearly, and I think my colleagues are going to talk much more about this, there are distortions in the incentives of financial institutions and other private actors from these guarantees. I'm going to focus more narrowly on the costs.
I also think, just in terms of thinking about the trade-offs. Obviously, if you don't know the cost, you can't do cost-benefit analysis. There's still a lot of disagreement on whether the benefits of certain actions did justify the costs, or what other alternatives that might have been cheaper might have done. I think very much now there is the need for more consideration of the cost of regulations, and whether the burden that regulations put on the private financial system are worthwhile in terms of harms averted. You can't even talk about the cost of harms averted without talking about their cost.
I think, probably overoptimistically, that if we could at least agree on what I think you might all consider a somewhat narrow measure of the costs, that it will help us come to some kind of a greater consensus about what the right thing to do is. On top of that very general statement, I also want to say that for decades I've been advocating for governments to move to a fair value basis of accounting for recording the cost of all of this. Why fair value? Basically, what it's saying is that the cost of a guarantee is pretty much what the private sector would charge to make the guarantee. I would note that when the government is doing anything else, it's buying things at market prices. There's kind of a comparability criteria that you want to really talk about the cost. We think of market prices as certainly not perfect indicators of social costs, but maybe the best thing that we have available that we can use consistently.
Why do I make a federal case, so to speak, out of fair value measurement? I just want to note that governments in general, the US government, too, almost always when they're doing any kind of a discounted present value use their own borrowing rate. I just want to point out why this is so wrong for credit. It's basically that Treasury rates are the price of risk-free government bonds, but Treasury rates don't help you price risky assets. If the government takes the risk of a loan and puts it on their balance sheet, and it's a balance sheet I have there, that risky asset might notionally be covered by issuing government debt. In fact, if the loans are risky, someone has to absorb that risk, and it's going to be ultimately the taxpayers or other government stakeholders. I always describe taxpayers or other stakeholders as conscripted equity holders in all the risky investments that governments make.
Trying to pause here for a second. We need to somehow do risk adjustment to capture the cost of the risk involved in these contingent liabilities. Just to kind of pause and say, "Well, bailouts and credit guarantees, they generate risky cash flows over very long horizons, so if we want to account for horizon and risk we're going to have to use an accrual method of accounting, not a cash basis. We need things to be forward-looking. We need to consider the entire distribution of possible outcomes, good and bad. We need to get the discount rates right, and hence not just use Treasury rates, then we need to figure out the NPV."
That's going to be my idea of a fair value cost of these kinds of guarantees. I'm a finance professor so I can't help saying that these contingent liabilities have the nature of a put option. Why does that matter? It matters because they absorb a huge amount of priced risk, or market risk. They don't feel that risky. If you look at the expected payout on a put option, it's much, much less than its cost. Because when bailouts happen, when loan guarantees are called upon, it's when the economy is in the worst possible state. Those are really expensive commitments, and it's really hard to see the expense of those commitments when you just look at expected cash flows.
A small thing that I really have emphasized a lot in other contexts is you also don't want to let government analysts do whatever they want. You need some discipline. I think it's basically fair value or government discount rates, and I'm voting for fair value in part because the whole private sector has come to terms with having to use fair value for very complicated financial commitments. They managed to do it, and there is discipline there. I think we can produce credible estimates of cost in the public sector, too. I want to show you that with the examples of what happened during the GFC bailouts and also for the COVID credit programs. Lest you think that I'm done with the theory, I'm not, because it's actually quite tricky to talk about all of this.
The first thing is bailout. What's a bailout? I mean, it's not a technical term. It's colloquial for providing financial help for a corporation or a country that otherwise would be on the brink of failure. That's a Wikipedia definition. I like to ask people, "If your house is privately insured, and the insurance company pays to rebuild it, is that a bailout?" You would go, "No, it's not a bailout." Okay. What if your house is uninsured, and your rich Uncle Sam comes in and rebuilds your house for you? That's a bailout. To operationalize the definition of bailout, I basically follow that intuition in saying that I'm going to call something a bailout if there's a realization of a significant payout from the government arising from a subsidized guarantee or implicit guarantee. If no one's paid for that ex ante, then it's a bailout. If they have paid for it, it's not a bailout.
What we're going to see is, it's a little bit of a slippery slope between the two of them. That gets to this issue of, well, why put bailouts and credit guarantees in the same paper? It's actually something I've never done before, and I was excited to have the opportunity to think about that. I think governments are basically making these explicit and implicit credit guarantees, and it's giving rise to really trillions and trillions of dollars of contingent liabilities. Typically, those guarantees at the time that they're made are subsidized. There might be some kind of a premium paid, but it's not really covering the cost. I guess something I wanted to say, and I threw it in here, but I think it's really important. This is a monetary audience, yet bailouts and guarantees have a very fundamentally fiscal element. As I'm talking about it, a lot of what I have to say will feel fiscal rather than monetary, but I will circle back and tie it to monetary policy.
In any case, these guarantees, in a way, are an alternative to traditional fiscal assistance. We have all these contingent liabilities, and it actually doesn't become a bailout until a payment is actually made. Bailouts are ex post, and the guarantees or the contingent liabilities are ex ante. Bailouts also are fiscal actions that the central bank participates in but doesn't really fund. As I said before, it's kind of a slippery slope between bailouts and guarantees, because if you think about your typical bailout, how might you accomplish it? You might accomplish it by providing additional guarantees. The bank is going bankrupt, so what do we do? We take the deposits and we give them extended guarantees.
Still a little bit more of complication. Now I'm moving to: what about a bailout? Well, you have to think about when exactly you want to think about the cost. This looks a little complicated, but I just want to say if you're thinking about a bailout, you might ask the question, "Well, what's the cost of bailouts from the perspective of a normal year, like 2006?" In 2006, the crisis was very unlikely, so bailouts were very unlikely. If you get to 2008, you're at the point of a crisis and you know the bailout is going to happen. It's going to look much more expensive then. If you're looking back at bailouts—ex post, say from a future year, 2018—you can actually see what's happened. I need to get through this, but I'm going to say in terms of the right time to recognize the cost, I think at the time of the bailout is the right time to recognize the cost. I'm going to be looking at the cost of bailouts during the GFC as of the time that they were made around 2008, 2009.
This is a summary from a paper I wrote at the 10-year anniversary of the crisis for the Annual Review of Financial Economics on the cost of the GFC bailouts on a fair value basis. It's about half a trillion dollars, $500 billion in total. You can see Fannie and Freddie were the largest piece. I have the Federal Housing Administration there, which I don't really have time to talk about. TARP: important, but only at about $90 billion. I want to say a few words about the Federal Reserve facilities, and I'm not going to talk about the FDIC or the Small Business Lending Fund, but it was about 3.5 percent of 2009 GDP, by my estimates. I just want to point out that for Fannie and Freddie, as of the time of the bailout, obviously, they were ground zero because they had all those defaulted mortgages. I took the estimate from CBO, which actually does do some fair value estimation. The beneficiaries were really the creditors of Fannie and Freddie, not their stockholders, who were essentially wiped out and remain essentially wiped out. Just by contrast, about $311 billion. I wrote a paper about the cost of Fannie and Freddie back in 2006 and said, "Forward looking, what's the value of their implicit guarantee?" Two orders of magnitude smaller. Again, that's because a bailout, prospectively, is a pretty low probability event.
Now, there's some use to both of those two points of reference. What is really annoying is what the press, and politicians, and many economists, actually do. They look at the cost in terms of ex-post "profit." They're looking back at a single realization, not at the whole possible set of outcomes, some of which could have been very bad, and they say, "Oh, well, actually we made money because we got back every penny." If you look at the press accounts...ProPublica: "the government profits $86 billion." Barack Obama, who I love, but not in this respect, loved to say we got back every dime used to rescue the bank. They got every dime back from the auto companies, too. Got a lot of dimes. That ex-post accounting is really problematic, and it's one of the things I think that really encourages a lot of reliance.
On the other side, there are people who overstate the cost of the bailouts, who really hate them. Forbes, for instance, had an article saying it cost the government $16.8 trillion, and that was just based on the exposure rather than the outcome. This again is the hope that if you actually measure these things officially and properly, you'd bring at least a little more consensus to people's view of what was going on. I'm going to skip down to...TARP was interesting. We can talk about it. I want to talk a little bit about the Federal Reserve facilities. When I went back to CBO right after the crisis, this is the first paper we wrote. These emergency facilities that are very useful for many things, are still not entirely free because, basically, the Fed is buying risky securities. In terms of my notion of cost, fair value costs, the question is, are they taking uncompensated risk?
I want to say that the Fed and the US government, for the most part, are aware of the idea that there should be a line between fiscal and monetary policy, that the Fed shouldn't be taking uncompensated credit risk. For instance, during the TARP funding, where the Fed was front and center of some of the actions that were taken, the big risk was absorbed by congressional legislation that authorized money. They had TARP backing, or there was a lot of collateral, or they bought things at a fair value like in the case of Maiden Lane. There was a lot of exposure. Ex post, the Fed probably did make money on all of this, but the potential credit exposure was really very large.
I promised to say something about the COVID-19 credit guarantees. They also cost a lot of money, and that also was not recognized very well. You can read the paper to see that. I just want to end by saying something about the Federal Reserve during COVID. This came up in some of the earlier sessions. As you mostly all know, the Federal Reserve reintroduced the emergency facilities that were standing there to provide liquidity if it became necessary. They had invented these for the GFC and rolled them mostly back out. There were new programs that were notably different, in particular the Main Street Lending Program put the Fed in the position of buying primary market loans from small and mid-sized businesses. I think this was really a large deviation from at least my expectations of what the Fed would have wanted to do because it put it in the position of picking winners and losers and potentially losing money.
I think it really brings, again, the question of, where is the line between monetary and fiscal policy, and what were the subsidies involved? I'm going to stop there because I'm pretty sure I'm out of time. The direct costs of the bailouts were about $500 billion, unsecured creditors were the main beneficiaries, and today's subsidized guarantees are tomorrow's potential bailouts. Thank you.
Phil Strahan: Thank you guys for inviting me to this great conference. This has been educational for me, and I'm honored to be here. I guess my only complaint is that I haven't seen my armadillo yet. I'm hoping tonight I will. I very much enjoyed reading Debbie's paper and I'm basically on board with why it is important to value bailouts and guarantees. I'm totally on board with the basic approach of basically taking the tools of financial market valuation and applying them to government guarantees and bailouts. That means identifying expected cash flows, valuing them, and taking account of time value of money, and making the appropriate risk adjustments. To answer Ron's first question, this is a really important thing to do because it helps educate taxpayers, whose money is being used to provide these kinds of guarantees and bailouts.
On those big questions, I'm totally with the whole exercise. I'm going to talk about three things over the next 15 minutes or so. First, I want to think a little bit more about the conceptual distinction between a guarantee and a bailout. Debbie said a little bit about that, I'll say a little bit more. Second, I want to talk about kinds of costs that go beyond the things that are being measured in this work. This is basically the idea that guarantees and bailouts distort incentives of economic actors, and those distortions can lead to bad decisions, bad investments. That will lead me into some linkages or thoughts on what's going on right now in our banking system.
First, bailouts and guarantees. Conceptually, what are we talking about? The cleanest way for me to think about it is, a guarantee is an ex-ante promise made by the government about providing some sort of insurance to a well-defined set of agents, under a well-defined set of economic scenarios. Typically, guarantees are based on legislative actions that have been made and are fairly transparent in that way. Things like deposit insurance, Small Business Administration guarantees, credit guarantees through the GSEs, et cetera.
These kinds of things are ex-ante promises. We can value them in a straightforward way because we know what we're looking at. We can assess the probability of a particular outcome, like a flood or a loan going down or a bank getting into trouble, then we can take the tools of finance to value those. Often those numbers come out fairly small, like the $8 billion number that Debbie mentioned regarding the implicit backing of the GSEs. That's because the outcomes where the government might step in are fairly rare, so the expected cash flows don't need to be particularly high.
Bailouts are more complicated and confusing even to think about. A bailout is an ex-post action that governments take in the heat of a crisis. What Debbie's paper is doing is it's finding places where governments went beyond the guarantees that had been made in law, in the heat of the moment, and figuring out what those cost at the beginning or when the decision was made to extend the bailout. In the context of the Global Financial Crisis, that means extending deposit insurance to all payments-related deposits. It means TARP guarantees of banks. The TARP was a legislative action, but it was one that was taken in the heat of the crisis. I don't know if you guys remember this, but the TARP legislation actually failed in the House of Representatives. The reaction in the market was so shockingly bad that I think they changed a few commas and added a few semicolons to the legislation, then over the next weekend they voted again and it passed. Other examples on the slide, and similarly in the context of the pandemic, we have legislative actions that are taken, the CARES Act is passed, but really this is under the gun, in the heat of the moment of the pandemic. We can value these bailouts after we know exactly what is going to be bailed out, using the tools that Debbie has in her paper.
What's harder to think about, though, are the many kinds of scenarios where governments might bail out in the future. In order to value those kinds of eventualities, we have to start arguing about: What are the economic scenarios where bailouts might be extended? What kinds of institutions might get bailed out? How much would that cost? What would the probabilities be? And so on. This is a much more ambitious thing to try to do. It's a much harder problem, so on the slide, I just in my head thought about, "Well, suppose one of the nonbank, phone-based payments providers got into trouble. Would they be bailed out?" It seems to me fairly likely that they might, because they're becoming more and more integral in the payments system, even though there's no ex-ante guarantee. What if there's a run on Tether, and they have to fire sell 10s or 50 or $100 billion in assets. Would there be an intervention? I don't know, but it seems possible that that might happen. The FSOC announced very recently that nonbank mortgage companies are potentially systemically important. Are they now on the list for potential future bailouts? Maybe. These are very difficult things to even think about, and our imagination is probably going to fail because the next crisis is probably going to look completely different from the ones that we've already seen.
One scenario that, it seems to me, almost surely will lead to a bailout. I'm mentioning this because it shows very clearly how bailout expectations distort incentives. Is the big one, the big earthquake that's at some point going to hit the West Coast? Geologists tell us it has to happen. What we don't know is when it's going to happen. The problem is because bailout expectations are so strong for that eventuality we don't see markets behaving the way they normally would. For example, banks don't require earthquake insurance to get a mortgage on the West Coast. It's hard for me to imagine that banks would behave this way if they didn't expect a bailout to come.
Now, why is that such a problem? It's a problem because imagine if all property holders in California had to purchase earthquake insurance. That's super-valuable, because the insurance business, their job in the economy is to explain to people how to manage risk. If I have to pay to buy earthquake insurance, I'm going to be incentivized, for example, to harden my property, and that will reduce the damage that happens when the big one actually comes. Those kinds of decisions are probably not being made because, I don't know what the fraction is, 10 percent, maybe a quarter of all property holders in California, actually do get earthquake insurance. Big picture: there are all of these unknown unknowns. How do we value the bailouts that might come in those situations? Very, very hard to think about that problem.
Second point, and this goes back to the incentive point I just made about earthquake insurance and the lack of banks insisting on that for mortgages are these broad sorts of moral hazard or incentive effects that occur when people expect bailouts. Ron and Gary Stern have a wonderful book, hopefully you've all read it, on "too big to fail," and it's basically fleshing out all the ways in which our financial system is riskier and more levered than it would be otherwise because of rational expectations that large and interconnected financial institutions would be bailed out. We've seen of course that this has happened, several times. On the slide, I added two additional margins of distortion that I think are important and underemphasized, so I wanted to drill into those a little bit more. One is on the incentive to invest in risk management, and the second is the fact that bailout expectations can be very harmful for market discipline, and I want to tell you why I think that's so important.
In terms of risk management incentives, this is my opportunity to plug some recent work that I've been doing in a new paper with two of my former students. What we're doing is we're trying to understand the demand for human capital at banks for people who have the skills to help them manage risk. We use data on online advertising. I won't go into the details about that, but basically the bottom line in that paper is it seems like the largest financial institutions are, if anything, underinvesting in risk management, human capital, relative to smaller banks, and not responding appropriately to things like being exposed to risk by increasing their investment in this human capital, unlike smaller banks. This aligns with the possibility that their incentives are undermined to some extent by expectations of bailouts that maybe smaller banks wouldn't have.
Related to market discipline, it's kind of ugly when it happens. What do I mean by market discipline? I mean sort of nasty things, like bank runs, or loss of funding, or loss of access to the repo market, or large financial institutions' cost of funds all of a sudden doubling and tripling or adding a zero to the rate they have to borrow at. These issues occur when people expect that they might lose money. If they expect bailouts, market discipline is going to be dramatically weakened. That is incredibly important because absent market discipline history I think has proved that regulators won't shut down failing financial institutions, particularly if they're large. We can look at history and see, go back to the first "too big to fail" bank, Continental Illinois. Why were they closed? They were closed because the bank was losing funding. If we look at the 1980s, we had hundreds, maybe thousands, of insolvent savings and loans which were not closed. Why weren't they closed? Because there was no market discipline. They were funded almost completely with insured deposits and it took a decade to resolve them. Then we look at the Global Financial Crisis. Again, it was the market that was forcing the interventions of the regulator. Bear Stearns losing access to the repo market, then you see the intervention. Fannie and Freddie's borrowing costs going through the roof in the summer of 2008, then you have interventions by the government.
When we have really strong bailout expectations and we undermine market discipline, this can lead to very pathological outcomes in the financial system. We get something that my colleague Ed Kane called "regulatory forbearance." This was the story of the 1980s and the savings institutions. Ed coined the phrase "zombie thrift." A zombie thrift isn't really alive and it isn't really dead. It's insolvent, but it can still fund itself because it has insured deposits. Zombies are bad, right? I hope you guys have seen the movie. Why are they bad? They're bad because they eat the brains of the living. In finance, what that means is zombie financial institutions are going to make decisions that hurt the healthy competitors. They're going to grow very aggressively, they're going to bid aggressively for funds, they're going to make loans on terms that no one else is going to want to make, and this is going to put pressure on the healthy. The sick institution can bring down the healthy. This brings me to the current moment. We have the Silicon Valley Bank, insolvent when, a year before it failed? Certainly six months before it failed. Why did SVB fail? It failed because of the run of uninsured deposits. You can disagree with me, but I'm going to argue that if those depositors hadn't run Silicon Valley Bank would still be with us. It would be a zombie institution, instead of a closed institution. I'd rather have it be a closed institution than a zombie.
This slide has some simple bond math that should make everyone nervous. It's just looking at how much the mark-to-market value losses probably are in our banks. I come up with a ballpark figure of about 7.5 percent, so that means if banks had 10 percent capital in 2022, now they have 2.5 percent capital on a mark-to-market basis. That's getting really close to failing. Here is the distribution of mark-to-market value of banks' capital asset ratios from 2022 before the interest rates went up and now after they've gone up. This is taken from a recent paper by Jiang et al. You can see in the data, before the interest rate shock, the banking system appeared very well capitalized. After the interest rate shock, if you mark down the value of the assets, the median capital ratio in their calculation is 0.4 percent. That's ridiculously low. Hundreds of banks are underwater by this calculation.
Now, one answer that sometimes people give is that this calculation doesn't account for the value of the deposit franchise, so when interest rates rise, the value of the deposit franchise rises to the extent that the wedge between market rates and deposit rates grows, which it typically does. In my view, that's a dangerous thing to rely on for two reasons. That franchise can go immediately if there's a run. That's what happened to SVB. You might say, "Well, we've solved that, because we're backing all the deposits. They're not going to run." That may be true, however the franchise can erode gradually just from competitive pressure. It's getting easier and easier for people to move money around, move money between banks, move money from banks to the markets. That's going to put more pressure on banks to raise deposit rates in order to keep the funds, and that's going to tend to narrow the wedge and therefore erode the deposit franchise.
I worry very much that we're now repeating the mistakes that were made with the S&Ls. In the early 1980s, the interest rates went up a lot and the S&Ls were hammered on a market value basis, because like the banks today, they were very heavily invested in real estate exposure. Real estate tends to have very long duration. That's just the way it works. Now we're doing it again. We have many, many banks, hundreds maybe, that are underwater on a market value basis. In the '80s, those insolvent institutions were basically propped up by changes in accounting that allowed them to continue. I'll be almost done. I know I'm going over. The good news is noises coming out of the regulators are the right noises. What I mean by that is things like saying, as Vice Chair Barr, I think, said yesterday, that they're thinking about extending to smaller banks the rule of passing through mark-to-market losses on held-to-maturity assets into the capital account. That seems to me very important, but I worry that it's going to take much too long to get there. Hopefully we'll get there quickly.
One more thing on the '80s. In the early 1990s, legislation was passed explicitly in response to the recognition of how bad a policy it is to allow the zombie thrifts to persist for a decade, and the concept was regulators should use prompt corrective action. Prompt corrective action means you either close an insolvent bank immediately or you force them to recapitalize. You don't wait. That's when you get the pathological, sort of second-order effects. I worry that we may be in a situation of waiting too long.
So just to end: I really like the paper, Debbie, and the exercise broadly that Debbie's been working on, in this and other papers. It's a really tough problem, especially when thinking about bailouts that haven't happened yet. It's like, what are they, how much do they cost? That's a much harder thing to do. The costs of these expectations of bailouts are potentially very large in distorting behavior of financial institutions and the real economy, distorting investment incentives, undermining incentives to manage risk. All of these things make us more vulnerable to the next crash. Just a final plea to regulators: Please don't repeat the mistakes made in the 1980s. Thank you very much.
Kevin Warsh: Thank you very much. It's an honor to be here. I was handling my seasonal allergies very well, then in the last panel I heard a detailed discussion of the 2008 financial crisis and it triggered like all the two years of pain that we suffered through. I'm going to try to make it through the next 15 minutes without popping another pill. It's an honor to be here. I'll try to make four introductory comments, then I'm going to heap praise on Debbie's paper, then give six broader implications for what I think this means for policy.
Normally, when I get invited to a Fed conference since I left the Fed in 2011, I'm invited as a critic. Hopefully a constructive critic, but to take issue with the conventional views. I was waiting to get Debbie's paper, just getting ready to like, you know, tee up for it, and I kept turning the pages and I kept agreeing with every bit of it. Most of my comments will be in the interest of piling on and sort of doubling down on some of the points that she makes.
First, to President Bostic: Thank you for inviting me and thank you for having this panel. The problem that we often have in policymaking is when we get hit by crises it's hard to think too deeply because we're trying to get out of harm's way. The central bank feels under enormous pressure. The central bank was created to deal with shocks, and so we try to get through the night, get through the week and the month. I'm somewhat sympathetic to what you do in dark and dangerous weekends. When the crisis passes, we then become often quite unwilling to think about substantive reforms. The crisis was a one-off. Congress seems to have calmed down, either through legislation or preoccupation with something else. What I give Raphael particular credit for is using this period of seeming calm to take up an issue which is perhaps somewhat arcane to the voters at home but deeply important to the conduct of policy.
If we're to get to the other side of improving the conduct of policy, especially by the central bank, then we've got to get out of this problem of just somehow waiting until the next crisis hits. The discussions of the last day and a half show a breadth and depth of both people and topics, and my number one proof about whether this is a serious Fed research discussion is if we can go an entire day without talking about dots. I think we've done that. That's my sense that we're talking about what's important versus what's imminent.
Second point at the opening is what's our job as policymakers? Most of us have been central bankers like me, many current policymakers in the audience. Our job is to get the big ideas right. If we think back on the crises, the shocks over the course of the last 15 or 20 years—the 2008 financial crisis, the pandemic crisis in 2020, the inflation crisis in 2021, the banking crisis that seemed to have been solved almost instantly in 2023—we should ask ourselves whether we're courting trouble. We should ask ourselves whether we can't perhaps forecast these shocks in advance, but we need to do a better job, in these periods of calm, of coming up with some ex-ante regimes, some frameworks to better deal with it.
That prior session that David led begged the question about whether US sovereign debt was at issue, whether new buyers might be willing to give us yet another intellectual Mulligan if there's a shock over the next couple of years. I understand a degree of complacency about that: "Well, you know, the world's stuck with the dollar, and the world's stuck with the US as providing the sovereign debt, the risk-free rate that the world relies on." That's all true, until precisely it's not true. If I think about those that are closer to the situation than me, some who has been a central banker, like Secretary Yellen, and those at the Treasury, it is revealing to me that both in October of last year and, I don't know, 10 days ago, they saw it necessary to, at the last moment, change the quarterly funding schedule for Treasury issuance, in both circumstances issuing more bills than markets were expecting and fewer longer-term securities, as if they might know something about the world's tolerance for this. Obviously, it's a time of war, a time of lots of risks. I'm sympathetic to the challenges there are, but I'm not totally dismissive that we know exactly when we're at turning points.
I'll spend most of the rest of my comments talking about broader implications of the bailout regimes. Third quick introductory point, if I might. The changes in the Fed and the Treasury in how we go to market, not just how we communicate, but how we conduct policy, as I think Debbie's paper made clear, show that the changes in these behaviors are maybe more pervasive since the Global Financial Crisis than most of us want to admit. The changes are so large, so significant in the last 15 years, that they're almost invisible: free money, massive liquidity, periodic bailouts of one sort over another, have backstopped the banking system in the US, and implicitly, the global banking system over the last 15 years. We should ask ourselves how long that can roll itself out. The language that you heard from my panelists here about puts and insurance: effectively, we've sold insurance to the banks, the GSEs, the financial markets, other central banks, the institutions they regulate, and protected them against some adverse outcomes. The point that I think Debbie's piece tries to raise is whether we've priced that insurance fully and captured it.
A fourth, probably somewhat less popular introductory point: many of the policy reforms that we put in place after the '08 crisis, with the best of intentions. If they have not worked as promised, they have not succeeded. Recall the Dodd-Frank Act as the "globally, most important systemic response to this crisis to ensure banks never put us in this situation again." Well, the weekend bailouts of Silicon Valley Bank, First Republic didn't break the system, but they revealed the frailties in the system that had long been broken. It's probably a different panel discussion to opine, but the Treasury and Fed announcements to make that crisis end, using Section 13(3), going to the edges of legal authorities, guaranteed all deposits. I remember as a young staffer in Washington before I was ever at the Fed, that Congress considered whether under various reforms, the FDIC, whether to guarantee all deposits of all banks. Our representatives, whether you like it or not, decided no, there would be a cap on those limits. There would be a premium. One weekend in a crisis, our authorities said, for now, we're backstopping them all. I haven't heard them correct the record in more benign times. So again, I'm sympathetic to how we have to act in weekends, less sympathetic to what we do before.
Now to Debbie's paper. I loved it. I must admit, as I told her in advance, I didn't know her scholarship as much as I should. I had known of her, but didn't know her scholarship, and it was my look into much of what she's done. I agree with it. In her summary to this group where she said the direct costs are $500 billion, I think she puts a lot of weight on the word "direct" there. That's carrying more water. If we go to a broader sense of costs beyond those costs, I think you can get to numbers that might not be rivaling the ones in her Forbes magazine article, but they'd be significantly greater. The balance of my remarks, I'm going to talk about what those are. I think her paper is a useful starting point that we should all broadly be able to agree on to capture at least the lower bound of what the costs have been to the system, and I'll dwell now on the societal costs.
Let me just show my cards so we're playing with everything above board at the gambling table. I've got three propositions, three premises, which might be a bit less popular than what we've talked about to this point. I happen to be of the view, especially for the United States, that there should be one risk-free asset. I disfavor proxies for the US Treasury, whether they be reserves, or GSE short-term funding, or short-term bills that are issued by too-big-to-fail institutions that are effectively backstopped by ours. I think the way these markets work, especially in crisis times, is when there's one asset, not a bunch of them that are trying to approximate a risk-free asset.
Second point, to show my cards: When we take actions in exigent circumstances, we should do all we can to avoid distributional consequences. That's central bank code words for helping those that have assets and doing harm to those that don't. This has a long history in the literature, going back to Sargent, where he says we want to inject cash neutrally. I don't think we've been great at that, not because we've been trying to provide liquidity for those that are already well off, but that's the nature, that's the transmission mechanism, of what you do on dark weekends.
Those are my priors. Now, the six broad implications. Number one, we should try to account for societal costs, not just the known direct liabilities, or even what was described as contingent liabilities. If we can't measure it, we can't manage it. We heard that from Ed last night. If we resist measurement, if the authorities are resisting measurement, might they be revealing something more bothersome? Might that say something about the political economy?
I can't help but think back to when I was relatively new in Washington. Dave Wessel was writing for a leading newspaper and I was going on and on with Ben Bernanke when we were at the White House with Greg Mankiw, when we were at the White House about the GSEs, about Fannie and Freddie and about their contingent liabilities. Our large fear was what would happen if not just they couldn't pay their losses. Those are the credit losses that we read about in Debbie's paper. What if they're not solvent institutions? What happens if the government has to stand in their shoes?
The liabilities, the debt issued by Fannie and Freddie and the Federal Home Loan Banks before the '08 financial crisis—this might be hard to believe—was larger than the United States sovereign debt. I will say I'm sort of scarred by that period, and the overwhelming consensus in the academic community among authorities, certainly among lobbyists, was this was just a distraction. Well, it didn't prove to be a distraction. I'm afraid it was a forewarning of other large institutions.
A second broad policy point: path dependency is the predominant driver of economic policy to date, and I think it explains our current conundrum. Again, I'll go back to the '08 financial crisis, when we did extraordinary things on 10 successive Sunday nights, because Chairman Bernanke was brilliant in his wisdom that every Sunday night we need to come up with something. I, naively, young member of the Board of Governors, said, "Well, what if we don't have something that would work?" He said, "Well, it'll be great if it works, but if it doesn't work, that's okay too, because markets have to know we're not quitting. Whatever you got, let's roll it out."
What I didn't appreciate then, and again, this was the naivete, is I thought we were going through a two-way door. In the dark days of the '08 crisis, we would bail out these institutions, we would do things, and we could call back to the other side of that door, on the other side. The last 15 years suggests that was a one-way door, and I think path dependency is the dominant reason for that. Not the bad intentions of policymakers, not some big fight between interest groups in Washington, but we've crossed that line. It seemed to work. I wonder what line we have to cross this time.
We see this path dependency in fiscal policy. When I was new in Washington, stimulus bills were hundreds of millions, then they were billions, and in the last few years, they've been trillions. We see it in entitlement policy: a sympathetic subgroup who are in harm's way through no fault of their own, war veterans, or something else. Then we find a similarly situated group, and another group that seems like we should also provide temporary relief. What do you know? We end up with entitlement programs that we have another poor job of providing fair accounting for.
Finally, the QE story. The QE that we created in the darkest days of the '08 financial crisis, and pledged to ourselves that when we get out of this, we are going to take this powerful tool, where one part of government is buying the debt of another part of government, and we would put the tool back. Not just behind the glass, but we put walls and barriers in front of it, because we knew it would be too tantalizing for the political economy if that were commonplace. Well, we're hundreds of QE programs later, and again path dependency, which now goes to Debbie's paper. The credit guarantees that we've extended, as her paper indicates, beget other credit guarantees. We provide extension of sovereign credit only for emergencies, then find that there are other similarly situated entities just at the perimeter of the Fed's backstop, and they look like they should need help, too. After all, if we draw too fine of a line, there will be risks in another part of the financial system.
A simple example: in the '08 crisis, we provided support, but only for US Treasuries, where we'd buy them, and mortgage-backed securities that were effectively backed by the GSEs. Go a couple of crises later, and as you heard earlier today, we're standing behind state and local bonds, corporate bonds, high-yield bonds. That was a line that we said we would never cross in the 2008 crisis. "Too big to fail" firms become systemically important. Banks and insurers, now we have nonbank mortgage providers on the list. Again, further extending the perimeter of the government backstop. This is a repeated game, and unless we take periods like this to properly account for them and to be honest about the path that we're on, we could come ourselves to one of those tipping points.
A third point, and I'll try to be brief, one of the most important transmission mechanisms of modern central bank policy, not just in bailout policy but in everything we do, is signaling. Market participants and firms take very seriously the signal that central bankers take. That's why there's all this forward guidance about the next cut or two, because we're providing signaling. They're looking back to how we responded when inflation was at different levels, and saying, "Boy, I think we've got the measure of that group. This is how they're going to respond." That happens in monetary policy, it happens in QE policy, and it happens in regulatory and bailout policy, too. No wonder, to my fellow panelists' point, no one's ensuring for earthquakes on the West Coast, because they think they've got our number. They've got us figured out. These repeated bailouts, under more euphemistic names, shape expectations. They leave less reason for people to self-insure. Fabio, rightly, I'm in his camp, where he says, "I don't like to invoke moral hazard doctrines, but we can't help but look and see what are the implications." Another way of thinking about these contingent liabilities is they're growing far beyond those contingencies, and we're massively understating the societal costs.
Point four: government guarantees significantly alter industry structure, and not in a good way. Industry structure is a shorthand way for thinking about how business should be conducted in a sector. In the wrong industry structure, we end up with businesses that are in practices that are anti-competitive and anti-innovative. If we do that, then the fate of our country is in much worse shape. Getting this right is important, and the government guarantees don't just bail out the least successful. I'd argue they do a lot of harm to the healthiest institutions, those that made all the right decisions on capital and liquidity. Those that didn't cut corners. When we change the industry structure and we let everybody effectively fund themselves as if they are the risk-free rate of the US, we're doing quite a bit of harm to important sectors. All the strength that you heard in the prior panel about the US and the dollar leading the world, it's not just because of network effects or because we were first after World War II. Even after those five shocks, the rest of the world still thinks we know what we're doing.
Point five, of six: unless we measure the cost of government guarantees accurately, we won't ever know when we've reached the tipping point. I said, much to the chagrin of some of my friends who are still at the central bank, some time ago, "There's nothing as expensive as free money." I'll add something to that today: it's free money and government guarantees in combination, which are probably the most expensive twin plot devices, artificial solutions to insoluble problems, and I worry about the overlap of these policies.
What happens when the daylight comes in and reveals the magic? The goal of Debbie's paper is to try to get in front of that, try to describe what these costs are, even if they're only the direct costs. Then we can engage on what these broader societal costs are, which again are quite a bit understated. The 40-year trend of long-term Treasuries use the 10- or 30-year Treasury, since the late 1970s, when Paul Volcker broke the back of inflation, and you'd say, "Gosh, the wind has been at our back. This is great news. Everything's in very good shape. We have nothing to worry about."
For reasons not just related to what we're talking about on this panel, or what the Fed is talking about as they meet at the FOMC, there's good reason to believe that we're at the turning point there. I'm not going to provide forecasts. I can't criticize my colleagues at the Fed for providing forecasts and provide one for the 10-year Treasury. I'm very open-minded that the broad trajectory of our government's risk-free rate is moving higher, and I can't help but think those that are closest to the center of the power are nervous about that. Hence, we see a bit of a dance between the Treasury and the Fed on QE and QT.
If that's true, and we start to incorporate these costs that Debbie outlines, we might ask ourselves, what's the cost of money for our businesses and households? As a final point, this expansive use of government guarantees runs the grave risk of altering the division of responsibility within other parts of the US government and raises important separation of powers issues. I gave the example before of how Congress considered whether there should be a full guarantee for all deposits, and they said no. Other parts of our government said yes. We do not want to be in a place where the Federal Reserve and the Treasury are the appellate courts for what the people's representatives have to say.
Again, I'm scarred by the '08 financial crisis. One of my jobs in working for Ben was to be a traffic cop. If people didn't get the answer they wanted for a bailout at the Congress, they came to see us, including the Detroit three. Part of it was, you've come to the wrong place, because the more we've gotten into this credit guarantee business, it turns out the line around our building gets longer. It's easier to convince us to do something than it is 435 members of the House with differing views and differing politics. We do not want to conflate the role of the Fed or the Treasury, as I fear we're doing in QE discussions. If we do, then questions will be raised about Fed independence. Like one of the earlier panelists, I think the Fed's independence is precious. It's incredibly valuable, but it's generally at its strongest when we're talking about interest rate policy. It is much less strong, and should be less strong, if we're talking about regulatory policy, or bailout policy. Debbie used the "F" word. Fiscal. That's not what we central bankers do. We shouldn't be surprised if more questions get raised as we go down this path-dependent policy. People wonder what this independence is really all about, and whether we're just hiding behind it when it's convenient. The growing specter of government guarantees may lead to a permanently diminished Congress. We might think that that's a good thing when we turn on cable TV, but it's quite dangerous for our constitutional system.
I'll end with a final point. I've said previously that I think running responsible monetary policy is more difficult when we have irresponsible fiscal policy. I'll add to that today. I think it's tougher to run responsible monetary policy when fiscal policy looks less responsible over the medium-term, and regulatory and bailout policy looks confused between and among these various parts. With that, I'll conclude by saying the US feels secure as we sit here. Measures of volatility in financial markets are as low as they have perhaps been in a very long time. It's easy to underestimate the scale of the challenges and the scope we have to fix them. The literature that Debbie has opened my eyes to and that you're all familiar with is a useful starting point to begin that broader discussion before we unfortunately find ourselves again in harm's way. Let me turn it back to Ron. Thank you.
Feldman: Debbie, before we turn to the questions that are here, did you have any thoughts that you wanted to share in response to what you've heard?
Lucas: Well, thank you for not ripping me apart. That was great. I guess there's one thing I want to say, which I find it ironic that people say $500 billion is kind of small compared to the cost. I mean, this is getting to the inflation of what governments are willing to shell out. I want to say that the reason I think it matters so much is, I spend a lot of time on the budget side of things. Zero is a magic number in government, and 500 is actually a big number. It's actually in the interest of getting Congress to say "no" to something. They're putting some number, even a small number like $500 billion, which is not small. I want to say that it's not that I'm saying these numbers are some kind of absolute truth, but putting any number on it, starts to give an incentive for the kind of discipline that you were looking for.
Feldman: Question: I'm going to paraphrase a question that's here. Just to follow up: the idea, of course, is, as it's been said several times already, if you measure it, you're more likely to manage it. I think the questioner is asking, "Boy, there feels like just a real credibility, time-consistency problem here that's intractable. That even if we measured it, that the concern people have about whichever guarantee they're going to need to make good on is the benefits are so large at that moment that even if you told them it was $8 billion, they wouldn't really be taking action and they would still do it anyway."
What's your thought? I mean, obviously this is sort of saying, "Yes, let's measure it." What's your view about the likely effect that's going to have, relative to the other forces that pull you towards the bailout, if you're a policymaker?
Lucas: I'll start. I agree with what others have said. When you're at that moment of crisis, you're going to do something, you're going to take some action. I actually think it matters which action you take, and when you know that you're going to have a price on it, it might change the action that you take. I think there's a lot of times where if it's free, you just kind of throw money at the wall.
Let's take TARP, which I didn't really have a lot of time to talk about. The government basically forced a lot of banks that didn't need it to take the money to take the so-called stigma away, which was kind of ridiculous, because everyone knew who was in trouble and who wasn't. In fact, the government threw out a lot more money in that action than I think, arguably, they might have needed to. If they had actually accounted for the fact that what they were getting in return, the preferred stock and the warrants, were worth less than what they were giving away, maybe there would have been some caution. I think a lot of times there's also some kind of subtle issues of policy trade-off. There's expensive and cheaper ways to do things, and this gets back to when it costs zero you just don't have to think very hard about what the alternatives are.
Warsh: I'll only add a couple of points. "Free" causes people to make a lot of bad decisions. In some sense, I think Debbie's point is, any price will do. Any price will then make people say, "Okay, what are the benefits that accrue to it?" I also think the benefit of a nonzero number, or a non-silly number, is we can ask the question, who decides? I might be old-fashioned here, but I believe in a unified government, but I believe in the division of responsibilities between and among us. I believe that the separation of powers really matters, and if the fiscal authorities need to provide some amount of money, even if they're confused about the difference between billions and trillions, at least they have to go through a process, say, "This is our choice," and whether we central bankers like the outcome of their choice, it has a truth to it because at least it went through the proper procedure. When it becomes free, I worry that we don't put the burden on them.
I'll just make a second, broader point: the rest of the world thinks differently about us in the United States than they did, let's say, before the 2008 financial crisis. They're less impressed that we know how to run a banking system, less impressed that we really know what price stability is about, less impressed that we have built a resilient financial system, as they see these things.
It's hard to measure them precisely, but one test of what the world thinks of us is when the G20 sit down at meetings. Back when I was in government, back when people had Blackberries and the rest, when the US spoke—I remember showing up in a staff job, then when I was with Ben first in 2006 at the Fed—when the Treasury Secretary or the Fed Chairman spoke people put down their devices, and they stood up and they took out their pens. I don't know if that happens in 2024. I hope it does. We need it to. I think if we take more seriously the need for these ex-ante protections, we're more likely to get the benefit of the doubt so that we're in a world where our allies trust us and our adversaries fear us some.
I don't think it's that important frankly, whether we decide that Debbie's number is right at $500 billion, or the number's a trillion. It's more important that we assign a number to it and we recognize both her direct costs and what are the second- and third-order costs that, in a different regime, we might be thinking harder about.
Feldman: There's another question that is asking a little bit about benefits. We've talked almost exclusively about costs. How should benefits be accounted for? For example, if you were thinking about benefits, would it make a difference if we're thinking about providing guarantees around COVID where everyone feels like they're an innocent victim, relative to something where it feels like there's some bankers who made bad decisions and let the costs go where they may? Debbie, we'll start with you. How do you think about benefits in any of the work that you've done?
Lucas: I get that question all the time, and I don't want to neglect benefits, but I'm going to say that because my focus has been so much on what Kevin's been emphasizing, which is the process for how fiscal decisions are made in the United States, if you think about the way we make any policy...let me talk about national defense. In the budget, we know exactly how much we spend for troops, and their health care, and their retirement benefits, and tanks, and everything else. That's the cost that we measure. What's national defense worth? Who knows?
We think, as a society, that it's worth what we're paying for it. At least our Congress thinks so. There's kind of a political process by which benefits are evaluated and weighed between different things. In order to bring this decision to use guarantee assistance into that same framework, we can help people with cash, we can help by making guarantees. To get that level playing field, it's really the costs that have to be equalized.
I don't doubt that in the middle of a crisis, it's amazing to be able to have a government that can help. An amazing fact about COVID, which I guess everyone knows but I want to mention, is when you look at the guarantee assistance in advanced economies, it's many multiples of what happened in less-developed countries. One of the luxuries that we have as rich countries is that our governments can be insurers, and insurers of last resort, and that creates enormous benefits. What we're worrying about is how long we're going to have that capacity and what we can do to make sure we maintain it.
Feldman: Phil, did you want to...
Strahan: I actually wanted to make this point at the end, and I forgot. It's important, it speaks to the benefits. I was talking a lot about indirect costs, and Kevin was as well, which would be basically on top of the kinds of costs that Debbie is computing. The problem is that all of these costs are really, really difficult to measure, and that's even a bigger problem for benefits because we don't get to observe the counterfactual world in which there was no intervention in the wake of Lehman Brothers bankruptcy, so we don't really know how much those losses might be.
The problem is that there's so much uncertainty on both the cost side and the benefit side, that people have their camps. You have the people that think intervention is a good idea, then you have the Libertarians who say, "No, don't bail them out. If you don't bail them out, market forces will come to the rescue, arbitragers will come in and fix the problem." Neither side can convince the other to move off their priors because there's just so much we don't understand about both costs and benefits.
Warsh: I'll just chip in. I agree with everything that my fellow panelists have said here. We didn't dwell, I don't think, on this panel on the benefits because everyone else seems to be dwelling on the benefits. There's this shocking asymmetry in the conduct of policy. Everyone says how magic it is, how we funded all these things with such great success, and there are no costs, really.
It is true, as one of the panelists earlier today said, that at some level it doesn't matter if the Fed is profitable. It doesn't matter whether we have a positive value. I'm open-minded to that idea, but the number of times that the authorities said, "...and we made money from these programs. This was such a profitable one. We sent $96 billion, year after year, back to the US Treasury." I think the reason why we didn't dwell on the benefits, Ron, is everyone else has.
Feldman: Yes. Federal Home Loan Banks. The same as the GSEs, that when you did your work that gave a guarantee, then it ended up being much more? Is that what they look like today? What kind of work should be done there to think about the costs that are implied in their existence?
Lucas: The group I used to run at CBO recently wrote a paper on the cost of the Federal Home Loan Banks. For many years we thought, it's not clear they need to be, anymore or ever. They look much less costly, much, much, much less costly, than the GSEs did prior to all the GSE problems, for many reasons. The Federal Home Loan Banks make highly collateralized loans. They're jointly and severally guaranteed. They don't really take that much risk. You can have all kinds of complaints about what they're doing, and I would even argue against those. I guess my short answer is, no, they're not the next Fannie and Freddie waiting to happen.
Warsh: I'll be short. My preference, just as a first approximation, is you're either part of the government or you're not. It makes our bookkeeping quite a bit easier, it makes the signal to markets quite a bit easier. If we've decided that mortgages are an important role for the federal government, it's not for us central bankers to make that judgment. That's for Congress to make.
I'd rather not let ideas get caught up in a semantic fog of, "They are, kind of, but not really." I want the Treasury market to be unambiguous. This represents the United States government, and the liabilities from it are not implicitly backing of anything else. They're ours, and here are the numbers. If you're in the private sector, that's a line we're going to respect, and you're over there.
I just generally worry about these institutions, and the guarantees that are associated, things that are in the muddled middle. Fannie and Freddie and the Federal Home Loan Banks have been through Congresses now for 40 or 50 years taking various views of them. I think broadly, both parties have decided that the government is standing behind these mortgages. The ambiguity, to me, and rival securities, to me, don't seem to be optimal.
We central bankers, we folks at the Fed, especially the New York Fed, want deep and liquid markets, especially on tough days in the Treasury market. I think that's been made more difficult because we have a variety of allegedly risk-free assets, including from some of these quasi-governmental enterprises.
Strahan: Can I ask you a follow up? When you mentioned the GSEs, do you think that we're better off having them in the government, or do you think they should be privatized? Both the Obama administration and the Trump administration made noises about privatizing them, but once you do that then you're in that ambiguity situation again of are they backed or are they not backed by the government? I'm wondering, do you have a view on that?
Warsh: Even has-been central bankers, we should respect the line. Congress, I think, keeps telling us, Democrats and Republicans, presidents of both parties, that these are effectively backed by the United States government. Let's just own that. I don't think it's worth the fight. This muddled middle with, "They're private until something bad happens, then what we're going to do, in our wisdom, is socialize the losses and let the profits be privatized in good times." This strikes me as the worst way for an American economy that needs durable, sustainable growth and credibility of the world, to proceed from here on out.
Lucas: I just have to comment again. You asked about the Federal Home Loan Banks that don't concern me. Keeping Fannie and Freddie nationalized greatly concerns me. There was a lot of progress on pretty reasonable legislation that would have taken them out of the government, put private capital in a first loss position, made the government backstop more explicit. It came pretty close.
The fact that there's no political will to do anything is a complicated. It's a great example of what you were arguing about, which is, you do these things and you normalize them, because just like we thought the Fed would draw down its balance sheet, we also thought that Fannie and Freddie would come out of conservatorship, and somehow we would bring more private market back into the mortgage market. I don't want to be quite as nihilistic as you are in that regard. I just think the Federal Home Loan Banks at this point are kind of an annoying sideshow rather than a real risk.
Warsh: Let's be clear that calling the Federal Home Loan Banks an "annoying sideshow" was not mine. That was Debbie's.
Feldman: Debbie, this isn't an audience question. This is my question. An annoying sideshow or whatever you want to call them, does the fact that you look at the cost that they're imposing through the contingent support that they have, and it comes in at whatever is defined as a low number, does that in some way end up validating their existence when the benefits that...maybe this gets to the benefits part, the benefits part maybe isn't really clear why they're there to begin with. In some sense, does the low number...it is what it is, but is it also not reflective of the nature of the problem?
Lucas: I feel like they've become a little bit of a scapegoat for deeper problems and what was going on with SVB and all of that. I think they probably have a handful, or two handfuls, of basis point advantage from whatever shadow guarantees they have, or some liquidity advantage, and they probably passed some of that on. It's going to be useful for banks to try to raise money that way.
I also think that if they didn't exist, it's not clear the same thing wouldn't have happened because in fact the banks could have securitized some of their assets. They would have still stood in front of the FDIC and all because if you securitize something, that's pulling it off your balance sheet. That's why I think it's a sideshow. They happened to be a little cheaper so they came in, but I don't see what would have stopped the same thing from happening even if they hadn't been there. I think we really need to think about the more fundamental problems, like the fact that the banks haven't had to mark their losses to market, and the inability of many regulators to understand the difference between liquidity and solvency, when there was clearly a solvency problem where liquidity followed. Maybe this isn't the panel for talking about SVB, but that is my opinion.
Feldman: I'm going to read this question, just because if I try to summarize it, I'll mess it up. How should we determine the correct discount factor to apply to the government guarantees—that was a point of discussion—when the very existence of the guarantee changes the risk of the credit that's being guaranteed? As you were thinking about what the right discount rate should be, and I know discount rate discussions can get surprisingly heated, how do you think about it, given this question?
Lucas: I love discount rate discussions, so thank you for whoever asked that question. This does come up all the time. In general, discount rates are forward-looking, and so when governments intervene it does change the nature of what happens in the future. You can assume that if there's a good chance that it's going to stabilize the world, that's going to lower the discount rate that you use.
Just like the private sector is also forward-looking, and they're thinking, "Well, the government is intervening, and it's changing equilibrium." In the group that I ran at CBO that did this kind of thing, it was never that hard to really think about. You don't have to explicitly say things are absolutely better, or they're absolutely worse. These policies get announced, and in fact, the financial markets are responding to those policies, and the financial markets have a view of what they're likely to do to the equilibrium.
This fair value principle, that the markets have this collective wisdom about things, the tricky thing is actually when the markets are illiquid and disruptive and falling apart, then you can't actually look at a market price. That's a different kind of challenge. The reason I've been this big advocate of using a fair value framework rather than a market price framework is the accountants, believe it or not, were really clever about this because they said, "Well, when markets aren't functioning properly, you can use models, then just some normal notion of risk adjustment that sees through the disruption."
The reason I said earlier that I think that the private sector has just done this amazing job of valuing these complicated, illiquid things and coming to a reasonable analysis about this. I just need to tell this one anecdote. With TARP, I actually wound up working for Elizabeth Warren. She was running this Financial Crisis Inquiry Commission that actually commissioned Duff & Phelps to do a fair value estimate of the cost of TARP and the subsidies to the Bank. They did their thing, and I think they were paid nearly a million dollars for doing their thing. CBO also did their thing, for the same thing. Valuing TARP was really complicated because the banks were giving warrants and preferred stock at this very disrupted time. I'm proud to say that the CBO "practically free to the taxpayer" estimate, and the Duff & Phelps million-dollar estimate, were within shooting distance of each other.
To me, that was just a demonstration that even in these situations where markets are pretty disrupted, there's kind of an understanding. As someone said earlier, "Okay, call it half a billion, half a trillion dollars, call it a trillion dollars. It doesn't really matter." In fact, they get pretty close.
Again, really what we're dealing with isn't getting it exactly right. It's not saying it's zero, and saying it's zero is where we are now. Also, so you can all write to your Congresspeople, the US government just made it more illegal to use risk-adjusted discounting. That's the story. You all know that. OMB just changed the rules to basically codify all the things that I'm saying, you're basically not allowed to do when you're looking at investment policy for the United States.
Feldman: We've got just a minute or two, and rather than asking a question I'll just leave it open. Do any panelists have any final thoughts that they want to share that haven't been covered? With that, thanks again for the conference organizers. Thanks for the panelists.
Paula Tkac: The last "good afternoon" of the "good afternoons." Good afternoon. I hope that you've all had a thought-provoking and enjoyable two days. I know that I have. I've been sitting in the audience, and I'm a visual thinker, so I've been making a bit of a mind map on my notepad, of all the topics and the perspectives we've discussed. It probably won't surprise you that it now looks like a bit of a Gordian knot, with lots of interconnected arrows pointing at all of these topics, connecting interest rate policy, and balance sheet policy, international finance and macro risks, financial crises and banking supervision, lender of last resort and liquidity provision, which are not always the same thing.
Finally, the issue of government guarantees. For me, I know it's going to be a lot of fun tugging on these connections over the next days and weeks with my colleagues at the Atlanta Fed as we think about how to put this into practice in terms of research and policy. I hope you have as engaging and intellectually stimulating a time as you go back, with what you've learned here.
So many people have contributed to making this such a great conference, and on behalf of the Atlanta Fed team, I want to first start by thanking all of our moderators, presenters, paper writers, and all of you in the audience for all of your questions and conversations over the last two days. Give yourselves a round of applause.
Now, inside the Atlanta Fed, it definitely takes a village, so I do want to call out some people in particular and again have us express our joint appreciation for all of the work it took to put this on every year. It really is an amazing effort. Starting with the research planning team, which includes economists in our research department. If you guys want to stand, if you're in the room: Kris Gerardi, Camelia Minoiu, Brian Robertson, Mark Jensen, Nikolay Gospodinov, and Larry Wall. Our conference coordinators, Sandra Ghizoni, Kim Tyson, and Jenny Cater from public affairs. Then, the cast of thousands from across our Bank, including public affairs, events management, law enforcement, and staff from both Atlanta and our Jacksonville Branch. Thank you all.
This conference has been around...I think Raphael said we've had 28 of them. It really has been about 30 years as best we can tell, so it seems like this might be a good time to just take a minute or two and to reflect back, take a walk down memory lane, those of you that have been with us for quite a long time. Those of you that are new to this conference, you'll get to see some of what we've done in the past and look forward to what we might do in the future.
If you'll start the slideshow. There we go. The Financial Markets Conference: Taking stock of the last 30 years. In addition to thinking about the conference, I want to double down on recognition and recognize one member of our planning team who has been here the entire time, and that's Larry Wall.
Many of you know Larry personally, and of course if you've been here with us at the conference, you've interacted with him in many ways. He has been a key contributor, a leading light of the Financial Markets Conference, like I said, from the beginning. This is Larry's picture, joining the Atlanta Fed in 1982. One of his first papers. You can see, we were talking about the development of interstate banking at the time. Now here we are, discussing a post-pandemic, global financial system, with AI and all other kinds of things going on. In the interest of kind of walking down memory lane a little with Larry, here's some pictures from over the years. This I think was from when we were at Sea Island. Here's with John Redding and here's last year, facilitating with Charlie Calomiris at the final discussion.
Thank you, Larry, and best wishes on your retirement from the Federal Reserve. We look forward to continuing to work together, of course, but we really, really thank you. I personally thank you for everything you've taught me, and for all of the great work that we've done together.
Let's now take a walk down memory lane with respect to the Financial Markets Conference. This was the program for the first conference 30 years ago, and a quote from then-Chair Alan Greenspan. It's kind of interesting to me. You look at the quote and you think, well, this quote could apply to today. We're looking at new technologies, new instruments, new challenges, disturbances in one market or one country transmitting more rapidly across the world economy. This is 2024. In some sense, we keep coming back to the same things. Again, this year's theme of central banking in a post-pandemic financial system is particularly apt. The world changes around us, and it's our charge to try to change with it and follow our mission and do our best for the public.
Here, I'm just going to let you sit back and watch the amazing work of our graphic designers in Atlanta with our various titles over the years. 2000 was the first time that I was at the bank. We were talking about the electronification of equity trading. At the time that was a brand-new event. We then moved into conflicts of interest, hedge funds, credit derivatives there was the spring of 2007, and I don't even know how that possibly happened.
Now you'll see a lot of the conferences, we're talking about financial reform, and about understanding macroprudential supervision, how it ties to monetary policy, liquidity, much of which, again, we've talked about here, thinking about global financial risks. AI, some folks mentioned we did that a few years ago, fostering a resilient economy, then thinking about disruption and how we move forward into the post-pandemic financial system.
With that, I hope you enjoyed the little tour. We're certainly looking forward to next year. We would love any input that you have to offer about what you've enjoyed here, what you think might be great topics for us. Please save the date. It is not Mother's Day weekend. We will see you here again, May 18th to 21st.
I also have some housekeeping. We have our final keynote tonight with presidents Bostic, Mester, and Collins, at 7 p.m. I heard entertainment is promised, so I'm looking forward to that. Please join us online, for those of you joining, and for those in the room we're going to roll right into a reception and dinner. Tomorrow, we have shuttles going to the airport. You can check in at the registration table and breakfast will be available from 5:45 until 10 a.m. You won't be seeing me at the 5:45.
We will be sending a survey out, accessible via the app or email, to hear your feedback on the conference. We would love your input. We hope to see you again next year, and please enjoy the rest of your evening with us.