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America’s Financial Crisis

The United States is facing the greatest financial crisis since the Great Depression. Financial institutions are failing, as is confidence in the financial system.

Joetta Forsyth, PhD

U.S. Federal Reserve Chairman Ben Bernanke and U.S. Treasury Secretary Henry Paulson have testified that Congress must act immediately to bail out troubled financial institutions, or we could face a financial collapse. There is much furor over the proposed $700 billion bailout, which didn’t get the required number of votes today to pass the House. Why, taxpayers ask, should people who were responsible and didn’t buy a house that they couldn’t afford, pay to bail out people who did, along with Wall Street fat cats? Exacerbating the problem is the fact the some of the people who are viewed as contributing to the crisis are now asking Americans to trust them to solve the crisis, using what could be an enormous amount of taxpayer dollars.

I share the same fury. And there is plenty of blame to go around. However, I would like to focus on the immediate problem. We are being told that something has to be done immediately, or we might have a financial collapse.

The key questions are:

  • Are we really facing a financial collapse?
  • Will this collapse happen rapidly or can we intervene if necessary later?
  • What would be the consequences of a financial collapse?

If a financial collapse isn’t of immediate concern, or the consequences aren’t great, then we should take our time, and get the bailout right, including as much taxpayer protection as possible.

On the other hand, if we do face an imminent collapse whose consequences are dire, then we shouldn’t split hairs but get something done immediately.

The consequences of the last financial collapse that started the Great Depression were dire. Bank after bank failed. The situation was like a row of falling dominoes. When a bank collapsed it failed to make good on deposits to customers and obligations to other institutions. This caused other banks to collapse, creating a “contagion.” Credit markets seized up, and ordinary businesses were unable to borrow to fund their inventory and other needs. Wall Street found its way to Main Street, as business after business failed. The result was systemic mass unemployment and the loss of retirement savings.

There are arguments to be made that a financial collapse wouldn’t be as bad this time around. After all, the Fed is a lot smarter. During the financial crisis that preceded the Great Depression the Fed withdrew money from the financial system, making it much harder for banks to survive. This time around the Fed is providing liquidity to the markets, as well as bailing out financial institutions perceived to be key to keeping the financial system sound. In addition, we now have depositor’s insurance. Bank customers presumably will not rush to withdraw money from banks because they know their money is safe.

I would argue that if not for these measures we would already have had a financial collapse.

However this doesn’t guarantee that one will not occur.

The problem is, that because risky mortgages were securitized and sold as collateralized debt obligations (CDOs), they are being held by a number of financial institutions, not just banks (See Why Did Subprime Loans Become Such a Big Deal?) And these institutions rely on short-term borrowing in the money market to finance themselves, which can dry up very quickly if there is a failure of confidence.

In addition, many have engaged in credit default swaps, which are like a form of insurance. The sellers of these swaps were guaranteeing the holders of the CDOs that they would pay in the event of default. As a consequence, the holders of these CDOs have not written them down. However, the institutions that sold the swaps are themselves on shaky ground, (which necessitated the bailout of AIG.)

The result of this is that financial institutions are tied to each other, and relying on each other’s solvency at an unprecedented scale. This problem is exacerbated by the large amount of borrowing that financial institutions have undertaken, particularly at investment banks, and by a lack of transparency.

No one really knows how much bad debt is being held, and the extent that each financial institution relies on the solvency of other institutions.

This has created a tremendous amount of fear and uncertainty. Investors began pulling money out of the money markets, causing the Fed to take the unprecedented measure of announcing that the government would guarantee money market funds. And banks are reluctant to lend to each other. These symptoms have all the makings of the beginning of a financial collapse.

I would also argue that since financial institutions use short term borrowing, a financial collapse could happen very quickly. When investors believe a financial institution is going to fail, it does fail because it cannot borrow.

So what will the consequences be?

Unlike during the depression, we now have unemployment insurance and other “automatic stabilizers” to dampen economic shocks. However, along with the bailouts that the government is making, adding the burden of supporting a large number of unemployed will put tremendous pressure on those taxpayers that still have a job. Yes, we are a lot smarter than during the Great Depression, but eventually even the government (taxpayers) may be pushed beyond their limits.

I would argue that an imperfect bailout plan is better than waiting. If we have a financial collapse, those with jobs will still be stuck with high taxes to support the unemployed and other government obligations.

And taxpayers can only be expected to lose part of the bailout package. It is like making a loan where only some of the money does not get paid back. The choice is a stark one. It is better to grumble about high taxes than have no job at all in an environment of high unemployment and taxes, and little retirement savings left. The consequences of waiting could be financial dominoes that start at Wall Street and end up on Main Street.

I am grateful to Jason Pena, a former BSM student for suggesting I write this, and I look forward to seeing the comments from the Pepperdine community and the readers of the GBR blog.

Joetta Forsyth, PhD, is an Assistant Professor of Finance at the Graziadio School of Business and Management of Pepperdine University.

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Author of the article
Joetta Forsyth, PhD, Assistant Professor of Finance
Joetta Forsyth, PhD, Assistant Professor of Finance
Joetta Forsyth, PhD, Assistant Professor of Finance
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