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Summary

  • Geithner was in the center of the 2008-09 Panic and this book provides a useful perspective from an excellent vantage point.
  • There are some "holes" in the analysis - why didn't authorities jump to action in 2007 when the subprime mess had been revealed and why wasn't it detected even earlier.
  • The book reveals that Dodd Frank may have actually made our financial system more dangerous.
  • I agree with Geithner on most points but I think he papers over some very tough and important issues.
  • The book supports an important thesis of mine - intelligent investors absolutely have to assess public policy responses and incorporate that assessment in their investment decisions.

Timothy Geithner's book refers to the Jimmy Stewart character in It's a Wonderful Life (I watch it every Christmas) and, if a biographical film based on Geithner's book were done and Jimmy Stewart were still alive, a smart casting director might give him the lead (among actors available today, I think I would go with Tom Hanks). Geithner describes his background and education and we get the picture of a regular guy and family man from a middle class background and Republican party affiliation who sort of wandered into a command position during a gargantuan financial fiasco. We almost get the feeling it could happen to any of us or one of our loved ones. The title refers both to Geithner's struggle with the crisis and to the test he imposed upon banks in 2009 designed to identify the need for more capital and provide more stability to the banking system. Both tests were survived and we can look back on the struggle with a sense of relief or, as Virgil put it, "forsan et haec olim meminisse juvabit" (maybe there will come a time when even this shipwreck is remembered with joy).

Of course, along the way Geithner got to be close to Henry Kissinger and Larry Summers and was put in the middle of the Asian financial crises of the 1990's. His thinking was very influenced by that experience as well as working with Ben Bernanke at the Federal Reserve. He developed a strong conviction that, in times of crisis, governments must protect creditors in order to stave off bank runs and the resulting economic carnage.

The public probably thinks of him as a friend of Wall Street and a kind of financial version of Caspar Weinberger (the Secretary of Defense who was described as "never meeting a weapons program he didn't like") who never met a bailout he didn't like. Thus, he was unfairly branded as a protector of Wall Street fat cats. I am sure that the book is a kind of apologia defending his actions; while I agree with Geithner on most points, I am not sure that the book will win over many of his critics.

On the Plus Side - I think he does an excellent job walking us through the 2008-2012 time period. He provides useful detail on the actions of the government. He is correct in arguing that Sheila Bair of the FDIC was wrong to stiff the Washington Mutual creditors (although I made a ton of money buying bonds of other large banks after this action because I was sure it wouldn't happen again). His book allows us to relive the Lehman debacle, the debt ceiling insanity and many other episodes along the way. At each point, he gives a cogent defense of his action and explains why he did what he did.

I think that his argument is incontrovertible. It was necessary to stop the "run" on short term financing (bank deposits, repo's, and money market funds) or else we could have had a repeat of the Great Depression or something even worse. It was simply not worth taking that chance by letting the financial fire burn out of control in order to teach imprudent investors a "lesson." Time and again, he criticizes what he describes as the "Old Testament" approach of punishing imprudent behavior; in this regard, he should have emphasized that the Old Testament also contained provisions for a Jubilee or year in which all debts would be forgiven. At any rate, I think that, while there is an argument that "moral hazard" is increased by rescue efforts, in this case the costs of letting the fire of financial panic continue to burn would swamp the moral hazard dangers.

He also is a Keynesian and as Secretary of The Treasury he advocated deficit spending in order to revive the economy. Once again, I am in agreement although his lack of background in economics may have limited his ability to explain his actions in Congress and before the public. He also fell into the trap of following what he describes as a St. Augustine approach (make me virtuous but not right now) involving an assurance that measures would be taken in the future to reduce the deficit. It doesn't take a whiz at Economics to figure out that this means higher taxes down the road and that, as a result, households and businesses will reduce current spending in order to have the funds necessary to pay future taxes. Thus, the stimulative impact of deficit spending is undercut by lower household and business spending (it's called Ricardian Equivalence).

On the Minus Side - I have several criticisms of what is otherwise an excellent book. First of all, he should have taken the opportunity to explain to the American public exactly what a totally hands off approach to financial regulation by the federal government would involve. Thirty year fixed rate mortgages with no prepayment penalties would disappear. Without deposit insurance, households would have to spread deposits among multiple institutions and would have to hold considerable amounts of currency and coin. Money market funds might require notice before withdrawals or might impose withdrawal penalties. Home equity lines of credit (used to help start many small businesses) might be available only at very high interest rates. This should have been explained so that the public would fully appreciate the government's important role in preserving a stable financial system.

He doesn't walk us through the securitization of mortgages, why it became so important, how it developed into a bubble and what should be done about it in the future. He was President of the New York Fed starting in 2003 and, thus, was playing an important role during the time the bubble inflated. He doesn't really explain why the regulators missed the danger signs or how they could identify them in the future; post mortems are painful but might provide useful insight to successors in identifying future bubbles.

By the summer of 2007, the failure of two mortgage security hedge funds and Countrywide Financial as well as the decision of BNP Paribas to suspend withdrawals from its investment funds with exposure to US mortgages made it clear that something was terribly wrong. Regulators should have gotten together, circled the wagons, warned investment banks that they had to raise capital, and prepared for the worst. Reading the book, I get the sense that there was less of a concerted response than would have been appropriate. Again, he really does not present a counterfactual describing what should have been done and how things might have worked out differently.

Dodd Frank - Most disquieting of all is the description of Dodd Frank, the comprehensive "reform" legislation which was supposed to ensure that a crisis like this would never happen again. In Washington, there are periodic efforts to enact comprehensive "reform" legislation which attract numerous amendments in order to assure passage. These unwieldy pieces of legislation become longer and longer and build up a momentum based on a need to "show the country we are doing something" as well as a desire to feed the egos of the authors, committee chairs, and administration supporters. Most importantly, perhaps, a point is reached at which so much work and political capital has been invested in the process that the thought that the bill may not be passed and that all will have been for nought becomes unthinkable. In recent years, the result is usually a hodge podge of ill-considered fixes to problems which have already been resolved, giveaways to special interest groups, throwaways to populist sentiment, and can kicking to future rulemaking proceedings. A herd of camp following lobbyists are attracted to the process like flies to excrement and cheer the insanity on. The result is usually a gargantuan pile of paper that nobody really comprehends and a tacit understanding that problems can be "cleaned up" in rulemaking or in a future amendment of the "reform" legislation. Lawmaking used to be compared to the manufacture of sausages but the current process is more accurately analogized to the processing of solid waste.

Although Geithner tries to paper it over, reading between the lines in his book it is almost incontrovertible that Dodd Frank has made things worse. The legislation removed the two most important tools used to resolve the 2008 Crisis; it took away the FDIC's ability to extend deposit insurance to a wider range of bank obligations and it took away the Fed's authority to provide liquidity to individual non-banks. It also likely slowed down the recovery by casting a fog of uncertainty over bank regulation causing banks to be reluctant to lend until capital requirements and other regulations were clarified which may not occur until after my lifetime (I am 69 years old). Geithner was caught up in the momentum of "reform" legislation described above; he should have put his foot down and withdrawn his support. The book is somewhat ambivalent about the legislation and this is hardly reassuring.

Investment Implications - In the Fall of 2008, something very important happened. At a certain point, the federal government invoked the "systemic risk" language which gives the FDIC authority to be expansive in supporting bank creditors. From that point on, one could be relatively sure that no large bank would default on a credit obligation. At the same time, due to the recent Washington Mutual default, bank bonds were trading at deep discounts to par. One of the great trades in our lifetimes had been set up by the zig zag in public policy. Shortly thereafter, a number of entities lined up to become bank holding companies at which point the credit obligations of these entities would be more secure. GMAC bonds were being abandoned like hot potatoes at that very time they were about to become super safe. An investor studying the situation, assessing the law and regulations and understanding the players would have been very lonely but he could make an enormous profit at the very time the market was falling apart. I have to admit that my success with these strategies may have - to some degree - colored my analysis.

As events unfolded, I remember articles and comments decrying the federal "intervention" in the market and complaining about the federal government's support for certain investments. The answer to this is simple: an investor has to be cognizant of the federal (and other) government's policy now and in the future in deploying his or her funds. Public policy is an important part of the investment environment and it has to be analyzed and assessed in making investment decisions. It is possible for the market to get this very, very wrong and, when it does, it opens up huge profit opportunities.

Conclusion - This is an excellent book and Geithner has been an excellent public servant. We are lucky we had people like Geithner, Paulson and Bernanke positioned where they were when the proverbial organic compound hit the fan. I have quibbles here and there and I would love to have his thoughts on the period leading up to the crisis in more detail but that may be the subject of another book. We seem to have come through the mess reasonably well and Tim Geithner deserves a great deal of the credit. I hope we don't have to go through this kind of thing again but I think that it is almost inevitable that we will. I hope this book gets read by those in charge when the next financial panic hits. I guess that is about the highest recommendation one can give for this kind of book.

Source: Book Review: Stress Test By Timothy Geithner