Dean Frederick M. Lawrence, Professor Lawrence E. Mitchell, Professor Arthur E. Wilmarth, Jr., Professor Theresa A. Gabaldon, Professor Lawrence A. Cunningham, Associate Dean Susan L. Karamanian, Associate Dean Charlotte O. Wise, with the assistance of the GW Corporate and Business Law Society, and with the support of the SEC Historical Society, invite you to attend:
The Panic of 2008:
and Proposals for Reform
April 3-4, 2009
The George Washington University Law School
The Panic of 2008
Thirty years of substantial deregulation based largely on neoliberal free market philosophies unleashed a regime of finance capitalism in America. Many American industrial corporations began to increase reliance on debt in the 1980s. By the 1990s, commercial and investment banks had turned the invention of new financial derivatives into a major business, and generated huge profits from dealing and trading in them. They also discovered that profits from derivatives rose considerably as the instruments and underlying assets were increasingly leveraged. The mantra of “risk management” provided a tempting rationale for speculation that often assumed reckless dimensions. The American economy reached a point toward which it had aimed for a century—the dominance of finance over industry, as many of the best minds from the academy and the most talented from business were drawn to Wall Street.
As early as the 1950s, insightful thinkers like Peter Drucker predicted a shift in the American economy from manufacturing to service. Less clearly anticipated was a more dramatic and, ultimately, more significant, transformation, from production to finance. But the steady (if inconstant) bull market that began in the 1980s and resumed after the 1987 market crash made this shift look both inevitable and infinitely sustainable. By the late 1990s, there was widespread acceptance of the view that a new era in finance had come, that the old rules no longer applied and that virtually limitless wealth was available to those who invested in old and new forms of securities and relied on the inexhaustible ingenuity of American enterprise. After all, hadn’t old Junius Morgan himself instructed his son never to sell America short? A new era was at hand.
The phrase “New Era” was used both at the turn of the 20th century and in the late 1920s to describe the apparent repeal of the business cycle. The financial and economic ends of both exuberant eras were devastating. Yet the federal government at the turn of the 21st century serially dismantled many of the most important protections that resulted from the sad learning of the earlier period. Perhaps most significantly, the venerable Glass-Steagall Act which, from enactment in 1933 had helped to prevent the kind of wholesale banking panic that had episodically occurred in America before, was dismantled. For the first time since the National Banking Act of 1863, the federal government gave its explicit blessing to the nation’s most significant financial institutions—those responsible for sustaining and protecting credit supply and systemic financial integrity—to speculate in securities. Commercial banks blended with investment banks and the resulting “universal banks,” together with the remaining securities firms, increasingly leveraged their equity to generate higher profits. A compliant Securities and Exchange Commission, charged with ensuring the safety of American securities markets, stood back in the face of apparently increasing prosperity and, perhaps, some degree of misplaced faith in the integrity of market actors.
Meanwhile, the bursting of the dot.com bubble in the earliest years of the 21st century did little to dampen spirited speculation. Instead, the Federal Reserve’s accommodating monetary policy helped to spread the fever from stock markets to housing markets. A housing boom empowered homeowners to finance record levels of consumption by borrowing against the illusory growth in home values. Rising consumption produced a sharp increase in corporate profits. Analysts, traders, and investors celebrated record corporate profits while failing to see that, during the preceding three decades, internal equity had disappeared and had been replaced by debt. A new wave of leveraged buyouts swept through the economy as private equity firms repeated, with new variations, the takeover strategies Michael Milken pioneered during the 1980s. To protect themselves against such buyouts, incumbent managers borrowed heavily to “enhance shareholder value” by engaging in debt-laden internal restructurings to return capital to shareholders or by financing large share buybacks. The overleveraging of American industry proceeded in tandem with overleveraging of American housing. The proliferation of complex derivatives and a dramatic increase in off-balance sheet financing helped to mask the truth. American industrial corporations, financial institutions, and investors, had assumed and exposed the American economy to dangerous degrees of risk.
The triumph of the financial sector in America inspired imitators in the United Kingdom and Europe. U.K. and European universal banks followed similar strategies of underwriting speculative securities, dealing in complex derivatives, and promoting housing booms. Housing bubbles in the U.S., U.K. and European markets were borne by dramatic increases in housing prices and extension of mortgage credit to borrowers who could not afford to pay for homes they had purchased. In the United States, mortgage lending reached unprecedented levels, thanks to the willingness of mortgage lenders to create subprime and “Alt A” mortgages with low initial borrowing costs, as well as the Federal Reserve’s policy of maintaining historically low interest rates. Mortgage originators sold these risky mortgages to universal banks and investment banks, which repackaged them into mortgage-backed securities and collateralized debt obligations. Credit rating agencies gave their stamp of approval, and the volume of mortgage-related securities skyrocketed along with the steady rise in housing prices.
Unsustainably high housing prices began to plateau in 2006, and then to reverse in 2007, as interest rates edged upwards and monthly payments on subprime loans increased according to their contractual terms. With this puncturing of the housing bubble, investors became concerned about the security of any investments related to the housing market. In a manner eerily reminiscent of the Panic of 1907, starting in the summer and early autumn of 2007, gradually increasing fear created disturbances in American and international credit markets. The Federal Reserve and its U.K. and European counterparts responded, but their efforts proved ephemeral. Liquidity in financial markets evaporated, major financial institutions reported large losses, and some appeared to be near collapse.
Stronger institutions acquired weaker ones, starting in March 2008, when J.P. Morgan Chase announced its fire-sale acquisition of one of the world’s storied investment banks, Bear Stearns. The deal, supported by the Federal Reserve Board and Treasury Department, and financed with government financial guarantees, recalled James Pierpont Morgan’s own bail-out of the Trust Company of America during the Panic of 1907. In 2008, a brief early summer hiatus ensued, but then the American economy appeared to fall apart at the seams.
During 2008, the following massive firms, from every financial services industry, failed or were merged under federal government oversight: (1) investment banking: in addition to Bear Stearns were Lehman Brothers and Merrill Lynch; (2) commercial banking: Indy Mac, Wachovia, Washington Mutual; (3) insurance: American International Group; (4) mortgage finance: Countrywide, Fannie Mae, Freddie Mac. Despite billions of dollars of capital support provided by the federal government, even titans of commercial banking, Bank of America and Citigroup, teeter, and titans of investment banking, Goldman Sachs and Morgan Stanley, converted from investment banks into bank holding companies.
In the face of an early collapse of the stock market, Congress approved a $700 billion Troubled Assets Relief Program (TARP), urged by Treasury Secretary Henry Paulson as a tool to enable government buy-outs of devalued derivative securities. The program’s limited early successes led the Treasury Secretary quickly to enlarge TARP’s purpose extensively, into a program of government debt and equity financing for a cascade of failing financial institutions numbering in the hundreds or thousands. In a demonstration of how the financial crisis directly affected the real economy, the Bush administration also opted to use TARP funds to provide capital to the country’s automotive manufacturing sector, lending $14 billion to Chrysler and General Motors to attempt to avert their bankruptcies.
Despite unprecedented federal government financial intervention, the nation’s economy collapsed into the worst recession since the Great Depression of the 1930s. Many note that depression might be a more accurate description of the current economic state. The Obama administration took office armed with a proposed stimulus package for the real economy that is even larger than TARP. Yet the economy languishes. Many corporations that relied so heavily on debt financing no longer can support their operations and lack internal equity to sustain them. Unemployment rises toward levels not seen since the early 1970s, and home foreclosures multiply. The long-term consequences of the crisis for the American economy remain uncertain.
Deep anxiety continues. Investment professionals, participants in the crisis, policymakers, Members of Congress, academics, and the media all work to identify and understand the causes of the crisis, assess its continuing extent, and develop ways both to clean up the fallout and to prevent future panics or at least mitigate their magnitude. It is the purpose of this conference to explore these matters.
The Conference Committee
The views explicitly or implicitly expressed in this introductory essay do not necessarily represent a complete consensus of opinion of the members of the conference committee.