But the hole was so deep that the government feared a downward economic spiral if it did not enable the worst drivers – those that in fact caused the crash – the nation’s financial institutions. The mantra ‘too big to fail’ echoed with mind-numbing repetition throughout the halls of government. Ultimately the politicians heeded the call, propping up the banks with the largest bailouts in history. The Government took most of the bad assets of the private firms’ book and converted them into a public debt. After the bailouts, it was expected that the private financial institutions would be freed up to lend money to distressed individuals and businesses and get the economy rolling again.
But that didn’t happen. As time has revealed, instead of using Government largess to help troubled consumers and small businesses, the banks hoarded the cash, and compensated themselves handsomely. In fact, in 2009, less than a year after the government bailed them out, Wall Street rewarded itself with almost $144 billion, the largest compensation package in its history. Moreover, the firms still held plenty of toxic mortgages on their books. And to add insult to injury – they had lied about just needing to bail out their clients. After the dust settled it came to light that Goldman Sachs, one of the supposedly least affected banks – and one of the most arrogantly opposed to government regulation – received almost $3 billion in government funds to bail out its own losing trades.
Needless to say, investors were not impressed. They clung to the sidelines. There were, to borrow a term from the estimable Donald Rumsfeld, too many ‘unknown unknowns’ out in the street. Meanwhile, the government’s borrowing spree diluted the value of the dollar so much that yields on short term treasuries trailed nominal inflation. Even while hugging the curb investors were getting side-swiped. The second round of Government debt issuance, QE 2, lowered returns on ‘safe money’ further and forced shell-shocked investors back into the street. As a result, the stock market rallied in the last months of 2010 and early 20011.
Many pundits celebrated the stock market rally as a sign of the return of consumer confidence. This was far from the case. The big ‘dumb’ money (as many Wall Street traders glibly refer to it) – institutional investors such as state pension funds and private insurance pools – could not survive on the near zero interest rates they earned on public debt, and were forced back into the street. Their actuarial models, the means by which they paid claims, assumed risk-adjusted returns averaging between 5-8%. They were now earning less than 2%. Not only had they lost upwards of 40% of their capital in the downturn, but the anemic, jobless recovery combined with the retiring baby boom population, placed serious strains on their resources. The risk of not crossing the street spelled certain failure, even as the unknown risks of crossing loomed.
The situation in the street is not much better (and maybe worse) than it was in 2008. The same large firms control the majority of the nation’s financial assets. Only now, thanks to mergers and government bailouts, they’re even bigger. Individuals at the helm of these firms largely escaped scrutiny, not to mention punishment, because the problem was chalked up to ‘systemic risk.’ Therefore, he same incentives that drove these firms to ignore the stop signs and run over pedestrians persist today. And one more thing – the U.S. government, supposedly the grown-up in the game, became the most risky institution in America.
When is crossing the street safer than standing on the curb? When there is no curb.