Q&A with Allan H. Meltzer
This leading monetary policy scholar contends that the Geithner plan, like the bank rescue efforts of earlier Administrations, is part of a flawed and unsustainable approach where 'the bankers make the profits and the public, the taxpayers, take the losses.'
April 2, 2009
By Robert Stowe England
Allan H. Meltzer is professor of political economy at Carnegie Mellon University's Tepper School of Business in Pittsburgh, Pennsylvania. Born in 1928, he is widely viewed as one of the foremost experts on monetary policy. He served on the Council of Economic Advisors for both Presidents Kennedy and Reagan. Meltzer also served as chairman of the Shadow Open Market Committee from 1973 to 1999. The SOMC is a group of economists, analysts and bankers who meet periodically to discuss, evaluate and comment on the actions of the Federal Reserve's Federal Open Market Committee. For more than two decades, Meltzer has also been a visiting scholar at the American Enterprise Institute in Washington, D.C. He is the author of dozens of papers and books on the Federal Reserve, and is currently working on the second volume of his History of the Federal Reserve Bank, which covers the period from 1951 to the present day. Mr. England caught up with Dr. Meltzer at his office in Pittsburgh.
ENGLAND: What do you think of the Public-Private Investment Program (PPIP) recently announced by Treasury Secretary Timothy Geithner?
MELTZER: This is another bailout because most of the money is coming from the government and not the private sector. So, while it’s called a public-private partnership, the costs of the partnership are heavily skewed to the taxpayers.
MELTZER: So, let’s go to the fundamentals first. The system that we have had cannot survive for very much longer if the bankers make the profits and the public, the taxpayers, take the losses. That’s a system that the Obama Administration, and the [former Treasury Secretary Hank] Paulson [and the Bush] Administration and previous administrations have developed.
ENGLAND: What do you think should be done in the alternative?
MELTZER: I proposed [to them] months ago when the Paulson Treasury was still there that they have a system which says to banks that need financing: You raise half the capital in the marketplace and we’ll give you concessional loans for the other half. If you can’t raise the [first] half [of needed capital] in the capital markets, then you’re going to be subject to the law called FDICIA [the Federal Deposit Insurance Corporation Improvement Act of 1991], which means we can take you over, wipe out the management, take over the stockholders and sell the parts of the bank that are still viable. That’s what I think they should do. Where they can’t do that or think they can’t do that, then they should use the bankruptcy law as an incentive to raise the private capital.
ENGLAND: Now, FDICIA was the law that came out of the savings and loan crisis in the early 1990s?
MELTZER: Right. And why did that law come out? It’s very important to recognize why it came out. At a time when the Administration is saying what we need is a super regulator like the Fed, that law came out because the Fed would hold on to banks much too long by lending to them to keep them solvent or appearing solvent, and then dump the problems on the FDIC. Congress was alarmed at the fact that FDIC funds were running down, so they passed FDICIA to tell the banks they should have structured early recognition [by regulators of deteriorating conditions at a given financial depository institution].
ENGLAND: Taking over the banks brings up the question of nationalization. Somehow when that term is brought up, it tends to bring the debate to a halt because people get frightened of that idea. But, is it really nationalization?
MELTZER: No. Nationalization would mean that the government takes over the bank and owns it. My proposal is that they do what they did with, say . . . Continental Illinois [National Bank and Trust Company].
ENGLAND: From 1981?
MELTZER: I think 1984. Anyway they took it over, put in new management, took out the stockholders, and sold it to the Bank of America later.
ENGLAND: After it was in better shape, I guess they disposed of bad assets.
MELTZER: They sold them off and took the losses. The same thing [happened], by the way, with the savings and loans. We didn’t nationalize the savings and loans. We closed them down and sold off the bad assets.
ENGLAND: Since both of these examples show that this approach can work, why is it that policy makers today don’t look to that past success as something to emulate?
MELTZER: Because the Federal Reserve has always been captured by a combination of the New York banks and the Congress.
ENGLAND: The Geithner plan was probably originated in the New York Fed. At least that’s what people are saying.
ENGLAND: So, basically it appears that within the Fed the New York Fed has an inordinate influence.
MELTZER: The New York Fed has always had a big influence, not as big now as it did in the early days of the Fed, but still big. They are there and they know the people, all that stuff.
ENGLAND: They are on the ground, so to speak, with the too-big-to-fail institutions.
MELTZER: Right. And they have people in there every day looking at what they are doing.
ENGLAND: At these banks?
MELTZER: Yes. They have an army of people [from the Fed] at the banks.
ENGLAND: And now they would also have Fed people at such firms as Goldman Sachs.
MELTZER: Wherever they have lent money.
ENGLAND: Plus Goldman Sachs has become a bank holding company.
MELTZER: Right, the golden rule applied in this case is that he who has the gold, rules.
ENGLAND: And the Fed does not appear to be about to bite the bullet and move to shut down insolvent banks and dispose of their assets in a timely manner.
MELTZER: [They] never have. The reason we have such a crisis is that in March  the Fed followed its usual predilection and it bailed out Bear Stearns. It had been doing this with very, very few exceptions for 40 years. Then, suddenly, without any prior announcement [in September 2008], it let Lehman [Brothers] fail. That scared the devil out of the people who had money involved. In writing up my version of this [for my history of the Federal Reserve], I say if I had been running a portfolio at that point, I would have rushed for cash, too. And that’s what they did. You didn’t know what was going to happen next. There was no warning that you were going to let Lehman fail. And it deviated from a policy they followed for 40 years. Now I don’t like the policy. And, I believe . . . that the best way to protect ourselves, that is the taxpayers, is to tell the banks if you’re too big to fail, you’re too big.
ENGLAND: That would mean they have to be broken up.
MELTZER: Or made to hold additional capital as the size increases. But, they don’t do that [at the Fed]. And then they suddenly did it. And then you had Secretary Paulson, who couldn’t make up his mind from morning to night what he was going to do.
ENGLAND: He was practically Hamlet.
MELTZER: Well, that did not inspire confidence in the midst of a crisis.
ENGLAND: Going back to PPIP, how do you think that will function or work, the way it is set up?
MELTZER: The subsidy is so great to the investors, it’s generally believed it will push the price of these mortgages up. That will help the sellers to unload them.
ENGLAND: Or even be willing to sell.
MELTZER: Yes, or even be willing to sell – because the problem you saw before was if you sold them in mass, the price would almost certainly go down, so that people who were not bankrupt would be bankrupt or insolvent. The [PPIP] proposal seems to have developed a way to prevent that from happening by giving a big enough subsidy so that the buyers will share the subsidy with the sellers.
ENGLAND: I see.
MELTZER: The taxpayers, of course, will be at risk.
ENGLAND: Now, as one person I interviewed has said, PPIP looks like it was designed by the people who want to buy the assets. Do you think the potential investors – who have to have under management $10 billion in similar assets – are the same people who helped design PPIP?
MELTZER: Yes; that is, it appears to have been made as favorable as it possibly could be [towards potential investors] and to hide the way it has been made favorable, as governments often do, by talking about sharing the costs and public-private partnership and all that.
ENGLAND: And by calling them legacy assets instead of troubled assets.
ENGLAND: Do you think that the announcement today [April 2] from the Financial Accounting Standards Board (FASB) on mark-to-market accounting will affect the success of PPIP? The stock market has responded very well to the announcement and the Dow is above 8,000.
MELTZER: Well, sure, because it’s going to relieve pressures on the bank. Here’s the problem. Mark-to-market is a great idea if there is a market. Unfortunately there isn’t much of a market, so they use things like the ABX index to price these mortgages. The ABX index has very little to do with the value of the mortgages, and so [by relaying on the index to establish fair market value] we have generated losses. And because of Enron, the accounting firms are afraid to do anything about it.
ENGLAND: Right. Sure.
MELTZER: And you can’t blame them after what they did to . . . .
ENGLAND: Arthur Anderson. They were completely destroyed – talk about an incentive for accounting firms to be aggressive in marking down asset values.
MELTZER: I had this discussion with the honorable Lawrence Summers last summer and he said to me you’re supposed to be a market-oriented person. Why are you against mark-to-market? I said that I am not against mark-to-market when there is a market. When there isn’t a market, I don’t know what mark-to-market is. So, I want to use a substitute, which is discounted cash flow.
ENGLAND: I think that might be allowable under the new FASB interpretation.
MELTZER: [Summers] didn’t like that idea because he said, well, you can play games with choosing the discount rate. I think that’s a manageable problem. But anyway that’s where the discussion ended. So, I’m glad to see that they are going to do this. [And], despite all the warnings that people wouldn’t like it, you tell me the market is way up.
ENGLAND: Yes, it is. Not just financials, but the whole market is up. The Dow was up 8,000 earlier today [April 2].
MELTZER: That’s good.
ENGLAND: How would this affect the pricing of the assets under PPIP – or the willingness of the banks to sell if suddenly they don’t have to get rid of them?
MELTZER: Well, they don’t have to sell them all and they’ll undoubtedly want to diversify what they have and they should want to diversify what they have. They surely will want to reduce their risk.
ENGLAND: So, if they’re loaded up with a certain type of mortgage, they’ll get rid of some of that.
MELTZER: They’ll probably hold some and hope for the best.
ENGLAND: Some of the calculations on the rate of return for investors in the troubled assets range from 25 percent to over 40 percent, even taking into consideration that leverage will raise the price of the assets.
MELTZER: It’s because the government is putting up all the money.
ENGLAND: Do you know if anyone considered your idea of having the regulators tell banks to raise 50 percent in needed new capital and the government will guarantee a loan for the rest at favorable rates?
MELTZER: The only comment I got is from a Paulson Treasury, which is where I presented the idea, and the answer was the banks didn’t like that. It didn’t seem to me to be a very responsive answer. They may feel differently now that they’ve seen what the Congress has done [since then in proposals to limit bonuses and compensation]. But at the time they preferred to take the money from the government at concessional rates.
ENGLAND: Yes, now that we’ve seen the AIG lynch mob. . . .
MELTZER: Yes, it wasn’t as cheap as they thought it was.
ENGLAND: No. Does the fact that the mark-to-market rule has been changed before the implementation of PPIP ultimately reduce risks to the government and the taxpayer?
MELTZER: Yes. It means that if the banks actually use the new rule, and many of them will, then their losses will be smaller.
ENGLAND: I guess you saw the op-ed by Joseph Stiglitz in the New York Times yesterday [April 1] titled “Obama’s Ersatz Capitalism.”
ENGLAND: He has similar concerns to those expressed by you.
MELTZER: Yes, but he wants to make the banks fail; that is, force them into bankruptcy and have the government take them over. That’s not what I want. I want to force them to raise the capital privately. And if they can’t do that, then to declare them bankrupt or at least insolvent and then sell them off, not hold them.
ENGLAND: So, you think this can be done even with a very large institution without causing the kind of trouble we had when Lehman failed.
MELTZER: Yes. I think if you announced what you’re doing, there may be a market hit when you announce it because we would be giving up too big to fail, but we’ve got to give up too big to fail. There’s no long- term solution to these problems that doesn’t end up with less of too big to fail. We just can’t have a system, which we now have, in which the taxpayers take the losses and the bankers make the profits. Some politician is going to be smart enough to recognize that and campaign against it and it will be popular with the public. It just isn’t a good idea. That’s not the way the capitalist system is supposed to work.
ENGLAND: That’s sort of what Stiglitz was saying, but his proposal was a little bit harsher. Do you think your proposal can work and we wouldn’t have the terrible fallout we had with Lehman?
MELTZER: Correct. Provided you announce and prepare people for it. The problem with Lehman was not what they did, but the fact that they suddenly changed the policy they had followed for 40 years without making any prior warning.
ENGLAND: I see. Letting Lehman fail overnight could be the dumbest move ever, I think.
MELTZER: I think it ranks as one of the dumbest moves ever.
ENGLAND: What else needs to be done to address the current economic situation, especially the weak housing sector, which is still a cloud over the economy.
MELTZER: I proposed months ago [that Congress adopt] a plan that says that if you have unsold new houses, that the government, instead of doing all the finagling in the mortgage market, . . . . should tell buyers that if you make a down payment, we will give you a tax credit for the next year or two to clean up the stock of unsold houses. And several Congressmen called me about that and introduced it as part of the stimulus package.
ENGLAND: That’s the $8,000 tax credit.
MELTZER: And it stayed in the stimulus package until the very end at which time the Democrats in Congress in a caucus removed most of it. And the reason they removed most of it was because they were concerned that people might buy a second house because they were much more interested in redistribution than in solving the problem. If they had been interested in solving the problem, they wouldn’t care whether people bought a second or a third house. When they asked me about this I said I didn’t care if [former Presidential candidate, Senator] John McCain bought an eighth house.
MELTZER: The problem we want to solve is not to worry so much about whether we help people buy second houses but whether we get rid of the unsold stock of houses. That would do two very important things. One, it would lower the number of defaults in the future while the housing prices fall. And the second is, it would, of course, after awhile, stimulate [new housing] production. . . . You don’t have to know much about business recoveries to know that when recovery begins, it’s housing that leads the way. Well, that’s not going to happen this time, certainly not to the same degree. Now, I understand from [California Republican] Congressman [David] Dreier’s office that they either have or are about to re-introduce that – and that would be a good thing.
ENGLAND: I see all these real estate ads touting the $8,000 tax credit. Didn’t that make it into the stimulus bill?
MELTZER: Only for first time home buyers.
ENGLAND: So that part stayed in.
MELTZER: They don’t mind giving the subsidy; they just don’t want to give it to people who already own one house.
MELTZER: If you look at the stimulus package, it should be called the Redistribution Package. What they are concerned about is who gains. Goodness knows that taxpayers should not be the people who get a benefit from this!
ENGLAND: That seems to be the new ruling philosophy.
ENGLAND: So, Congressman Dreier might reintroduce the provision to cover anyone buying a house.
MELTZER: He’s going to put it back in. Yes. It’s slightly different now, from what I understand from his office, I believe they may have already offered it.
ENGLAND: Some states are also offering a credit – California, for example.
MELTZER: Yes, and they have a high enough [income] tax rate that it might help. But the federal [income] tax rate would do a lot. And, in my proposal I said that if you didn’t pay taxes you would get the benefit any way. We’d give you the cash.
ENGLAND: Did that survive?
MELTZER: I think it was in the bill Congressman Dreier and others offered.
ENGLAND: That’s redistributive, too, but it is not redistributive for the purpose of being redistributive, but because we’re trying to get rid of the excess supply of unsold houses.
MELTZER: Look, this crisis is not going to end until we clean up the housing stock and clean up the banking mess.
ENGLAND: I couldn’t agree more. Thank you for taking time to talk about these developments and issues.
i Allan Meltzer is correct. Continental Illinois was taken over in 1984.
ii The ABX Index is a series of credit-default swaps based on 20 bonds backed by subprime mortgages. A decline in the ABX Index reflects investors’ sentiment that subprime mortgage holders will face increased financial losses, while an increase represents the opposite. Credit quality assumptions are made in quarterly indexes: Second-quarter 2007 subprime RMBS are generally viewed to have better credit quality than those from first-quarter 2007. Historical trends can be found at the Web site for the ABX indexes (www.markit.com/information/affiliations/abx)
iii Lawrence Henry "Larry" Summers, a noted economist, is currently the Director of the White House's National Economic Council for President Barack Obama. He is also the Charles W. Eliot University Professor at Harvard University's Kennedy School of Government. He was Secretary of the Treasury near the end of the second term of Clinton Administration.
iv FASB's new guidance on mark-to-market accounting allows banks to use "significant judgment" when placing a value on illiquid assets such as residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDOs). The new approach, which relaxes the standard, is allowed when there is "significant decline of a market for new issuances," or, in plain English, there is no longer a new market for the class of securities being evaluated. The change came in response to pressure from Congress, which held hearings on mark-to-market accounting March 12, where FASB Chairman.
Copyright 2009© by Robert Stowe England