Kettl, Politics of the Administrative Process 7e

CQ Press, 2018

Case Archive

Chapter 7: Administrative Reform

Punching through on the Financial Bailout

On a quiet Sunday, Richard Fuld was working out on a treadmill. Another exerciser, in the corner lifting weights, noticed who was on the treadmill, walked over, and delivered a staggering punch.[1] Fuld was the head of Lehman Brothers, once one of Wall Street’s most distinguished investment banking firms. In the previous eight years, he had received about $300 million in pay and bonuses, only to see the firm declare bankruptcy amid the September 2008 financial crisis. The weightlifter did what many Americans were thinking. The deeper the financial markets fell, the more investors wanted to take a shot at those who, they believed, had caused the system to collapse.

Lehman Brothers was one of several companies at the center of the crisis. An investment banking firm, its managers worked hard to raise the money that fueled the economy. When companies needed to borrow money, for everything from building new manufacturing plants to funding big mergers, they went to investment banking firms. The investment bankers took the companies’ loans, packaged them, and sold them to investors. They did not have branch offices with tellers and ATMs. Rather, they operated out of big financial centers, especially New York, London, and Tokyo. Employees were the wheelers and dealers who made the deals that made so many of them rich.

The company was born when Henry Lehman, a German immigrant, came to Montgomery, Alabama, in 1844 to open a general store. It proved successful enough that his brothers Emanuel and Mayer joined him six years later. Together, they formed Lehman Brothers, which gradually grew from selling goods to brokering cotton, and they opened an office in New York. By the 1880s, they began making deals with merchants and became a Wall Street player. By its 150th birthday, it had become an international powerhouse, with new buildings in New York and London and high credit ratings to back up its success.

When the markets started going sour toward the end of 2008, however, they took Lehman down with them. Along with many other big banking and investment firms, Lehman had been a major player in the mortgage market. Financiers created new mortgages that allowed individuals to buy homes at below-market interest rates, with little or no money down. In turn, the financiers bought up millions of mortgages, packaged them, and sold them to investors looking for higher-than-normal returns. The flood of cash into the mortgage market helped fuel economic growth for much of the early part of the decade, and the deals made the investment bankers enormous amounts of money.

In 2008, however, the bubble burst. The value of homes dropped and the economy slowed. Homeowners struggled to pay their mortgages. That lowered the value of the mortgage investments that the financiers had sold. To make matters worse, investors had bought complex insurance packages (called “credit default swaps”) to back up their investments, but the value of this insurance plummeted. Within just a few weeks, the foundations of distinguished old firms like Lehman and Merrill Lynch crumbled. In just a day, the Bank of America bought Merrill Lynch, and Lehman Brothers declared bankruptcy. Other financial institutions around the world carved up the pieces of Lehman and bought them at bargain-basement prices.

People borrowed money they could not afford, and financial institutions put deals together that no one really understood. In fact, some of the analysts who framed the deals were Ph.D.s in theoretical physics and electrical engineering, who were brilliant mathematical modelers but who knew little about the financial instruments they helped create. In 1999, an editorial in Physics World noted the drift of highly trained researchers into investment banks.[2] As an observer blogged nine years later, “What if the rocket scientists make a mess of it?”[3] They did—but they were not alone. Investors lost more than a trillion dollars within hours and the economy staggered.

As the collapse spread, first in the United States and then around the world, federal officials huddled over how best to shore up the economy. On September 6, Treasury Secretary Henry Paulson managed the takeover of the mortgage giants Freddie Mac and Fannie Mae by the Federal Housing Finance Agency. Fannie and Freddie were government corporations, chartered by Congress to help support mortgage lending but whose stock was held by private investors. (Analysts had long called them “quasi-governmental organizations,” because of their peculiar place in the nether world between the public and private sectors.) Fannie and Freddie together accounted for about half of the funds in the American mortgage market, and as mortgage investments soured they found themselves in financial trouble. The Treasury concluded it had little choice but to bail them out. Eleven days later, officials from the United States Department of the Treasury and the Federal Reserve System cobbled together a bailout of AIG, an international insurance giant, and helped finance the merger and takeover of several banks. A Pasadena-based bank, IndyMac, had failed in July and had cost the government insurance system $9 billion. More bank failures followed, even after the Treasury and Fed decisions.

Treasury Secretary Paulson concluded that making decisions one financial institution at a time was not working and that the federal government had no choice but to make a giant move to reassure the markets. On September 19, he proposed a $700 billion plan in which the government would borrow money to buy “toxic mortgages,” as analysts soon began calling them, from investment houses. By taking the bad loans off their books, Paulson hoped, the government could help stabilize the financial system. Five days later he sent a three-page bill to Congress to give the Treasury enormous power over gigantic sums of money. Political analysts immediately recognized that the idea of using that much government money to purchase loans from Wall Street financiers would be political poison. Rather than becoming known as an economic stabilization program, observers quickly called it a “Wall Street bailout.” Members of the House of Representatives balked at the bailout and voted it down by a 12-vote margin on September 29. The stock market plummeted, with the Dow Jones Industrial Average falling 778 points, the biggest one-day point drop to that point in history.

Two-thirds of Republicans and one-third of Democrats voted against the bill because it used an enormous amount of federal debt, backed by taxpayer dollars, to fund the bailout. Throughout American history, rifts between Wall Street and Main Street had often become heated battles. In the late 1700s, Alexander Hamilton had argued for a strong and aggressive national economic policy, and populists rose up against him. Both the First and Second Bank of the United States were closed because of populist opposition. In 1896, presidential candidate William Jennings Bryan mesmerized his audience by arguing, “you shall not press down upon the brow of labor this crown of thorns. You shall not crucify mankind upon a cross of gold,” in a powerful argument to help farmers against the power of bankers by increasing the supply of money. The House vote in September 2008 rejecting the bailout joined the monumental moments in American history where business and populist interests collided.

Paulson huddled with Fed Chairman Ben Bernanke to redraft the bill. To counter complaints that the bill was just a bailout and that it did not provide enough accountability over the decisions, the new draft created a Financial Stability Oversight Board to protect the taxpayers. The board comprised the Chairman of the Federal Reserve, the Secretary of the Treasury, the Director of the Federal Home Finance Agency, the Chairman of the Securities and Exchange Commission, and the Secretary of the Department of Housing and Urban Development. It required the Treasury secretary to make regular reports to Congress and to prepare periodic financial statements. In addition, the secretary would be required to recommend changes in the regulatory system. The Comptroller General, who heads Congress’s auditing agency, was required to conduct ongoing oversight and to report to Congress every two months on the effort. Congress itself would establish an oversight panel, consisting of five outside experts, and the FBI had power to investigate wrongdoing. The bill gave the secretary the right to set aside standard procurement rules, as set in law, as might be necessary to move quickly to administer the bailout. The Office of Management and Budget and the Congressional Budget Office were each required to issue regular reports on how much money the bailout cost.

With the new provisions—and $150 billion in special tax provisions added to the bill to curry support—the Senate and House both passed the bill within days. It was a tough vote, not only because of the sheer size of the bailout and the complexity of the system. Members of Congress were giving enormous power to the Treasury Department at a time when the only thing certain was that a new president—and, in all likelihood, a new Treasury secretary—would be taking office in just four months. Taxpayers remained furious. The decision by AIG executives to treat seventy top salespersons and executives to a $440,000 retreat at a luxurious California resort, just days after the Fed bailed out the company, enraged members of Congress. The $23,000 charge for spa treatments proved especially galling. “Shame on you,” scolded Rep. Jackie Speier (D-Calif.).[4]

Questions to Consider

  1. Once the “Wall Street bailout” label stuck, how did this change the debate over what to do and how to make it work?
  2. The original three-page bill would have given the Treasury secretary enormous power with few restrictions and little oversight. What issues do you think this might have raised? Would you have voted for the bill under these circumstances? (Remember that Congress initially failed to approve the $700 billion plan—and the American stock market lost more than $1 trillion in value the same day.)
  3. The Federal Reserve is an independent agency, with power to set policy on its own subject to only loose congressional and presidential control. The Treasury Department is an executive branch agency, whose secretary reports directly to the president and which administers policies as enacted by Congress. What implications for policymaking and accountability do you see in combining two such different agency structures in this bailout package?
  4. The bailout was placed administratively in the Department of the Treasury. Consider other administrative structures that the government could have used. The job could have been put within the Federal Reserve, into another independent agency, into a new agency which would be closed down as soon as the job was done, or in some other structure. What are the advantages and disadvantage of each? Do you think that Congress made the right decision in the end?
  5. Consider the accountability structure created for this effort. Do you feel comfortable that this system will protect taxpayers and ensure that the effort will work well? Are there alternatives you would suggest?

[1] Jon Swaine, “Richard Fuld Punched in Face in Lehman Brothers Gym,” Telegraph.co.uk, October 7, 2008, http://www.telegraph.co.uk/finance/financetopics/financialcrisis/ 3150319/Richard-Fuld-punched-in-face-in-Lehman-Brothers-gym.html.

[2] Editorial, “ ‘Rocket Science’: The Facts,” Physicsworld.com, June 3, 1999, http://physics world.com/cws/article/print/1081.

[3] Hamish Johnston, “Lehman Bros ‘Killed by Complexity,’ “ Physicsworld.com, September 16, 2008, http://physicsworld.com/blog/2008/09/killed_by_complexity_1.html.

[4] Peter Whoriskey, “AIG Spa Trip Fuels Fury on Hill,” Washington Post, October 8, 2008, D1.