The New Financial Deal

Monday, March 30, 2009

This session was part of the CFR Symposium on a Second Look at the Great Depression and the New Deal, cosponsored by Dean Thomas Cooley of the Leonard N. Stern School of Business, New York University, and supported by a special grant from the Ewing Marion Kauffman Foundation.

CHRYSTIA FREELAND: Okay, if everyone could please sit down I think we're ready to start. It looks like everyone has come back in from lunch. Welcome to our afternoon session. Our subject for this session is the new financial deal and what do the 1930s teach us about reforming today's financial market? I'm Chrystia Freeland. I'm the U.S. managing editor of the Financial Times, and so I guess it's very particularly relevant for me to inform you that this session is on the record. If you say something really explosive it might be in the FT tomorrow, so please try to do that. Please also turn off your cell phones and your BlackBerries.

What we're going to do is I'll, in a moment, introduce our panelists and then each one of them will make a few introductory remarks. I've warned our esteemed professors only to speak for five minutes. Then we'll have a little bit of discussion within the panel. And then I hope we'll have time for half an hour of questions from you and discussions with our esteemed panelists.

First of all I'd like to introduce, to my right, Dean Cooley of the Stern School of Business, who is the co-sponsor of today's conference and co-sponsor of many fun events at the Financial Times, so I'm especially happy to have him here. To my left is John Cochrane, the Milton (sic) Scholes Professor of Finance at the University of Chicago's Booth School of Business. At my far right is Professor Charles Geisst, professor of finance at Manhattan College. And then to my far left is Ingo Walter, the Seymour Milstein Professor of Finance and Corporate Governance and Ethics, also at the Stern School with Dean Cooley. I'm going to ask Dean Cooley to start with his introductory remarks.

THOMAS F. COOLEY: Okay, well, thank you very much. I apologize for my hoarse voice this afternoon. I'll try to speak up loudly so you can hear me. I'm glad for the microphone. I'm going to pick up where Bob Lucas left off, actually.

We heard a lot this morning about bad institutions and bad ideas that emerged out of the Great Depression, and what I want to do is talk about two things that emerged from the Depression that in fact turned out to service quite well. And I want to use those as examples of how we think about institutions in the context of the discussion that's going on now and is going to be going on for some time to come about how we re-regulate or restructure the architecture of our financial system. And it doesn't matter whether the successful results of these institutions were the consequence of intelligent design or luck, but as economists we can look back and think about why the worked, why they were successful, and use that as perhaps the beginning of a set of principles for how we think about institutions for the future. And the first of these is the Glass-Steagall Act, which was accompanied by the creation of the Federal Deposit Insurance Corporation.

So between 1929 and 1933 when Roosevelt took office there were enormous waves of bank failures. As Michael Bordo alluded to this morning, when Roosevelt took office we were in the midst of yet another bank run, which was the source of Roosevelt's famous line about. "The only thing we have to fear is fear itself." And there was tremendous, tremendous panic about the security and soundness of the banking system. What they did is they declared a bank holiday. The used the word "holiday" to try to make it sound a bit more cheerful as opposed to a bank deathwatch or something like that. (Laughter.) They did an immediate stress testing of those institutions and the only ones that they allowed to reopen after that were the ones that they could certify were solvent.

Still, in 1933 something like 4,000 banks were closed or failed, but what they put in place at that time was the Glass-Steagall Act and the Federal Deposit Insurance Corporation. And I'll come back and talk about why that was successful, but my measure of success is that we haven't had a bank run since then. We've had many, many decades of relative stability. Banks have failed but they've failed in orderly ways and we've had a well-functioning financial intermediation system that's, arguably, served our economy very well. The other institutions that I think served us very well in the aftermath were created by the Securities Acts of '33 and 34, and that was the Securities and Exchange Commission, and I would argue that that bit of regulatory engineering created a financial system that has been the envy of the world for virtually all of the decades since.

So why were they successful? What made them successful in contrast to a lot of the programs that were put in place that were not successful? The reason they were successful is because they solved a problem of market failure. They recognized how markets were failing and they solved them in a way that was not hostile to the marketplace or to innovation in the future. So in the case of the FDIC and Glass-Steagall, what they did is they recognized that there was a huge information problem affecting the banking sector and that there were problems created by the combination of risks from a large set of activities, together with deposit-taking activities. And the creation of the FDIC made uncertainty about bank soundness essentially irrelevant for the decades since. And the last part of the design of that, which was very important, was that they recognized the moral hazard problem and they did so by requiring that the banks pay for the cost of the insurance. So rather than it being a mis-priced guarantee, the idea was that it would be priced correctly and that the banks that created risk would be paying for that risk.

In the case of the SEC, obviously there was a tremendous information problem in financial markets. People did not know the quality of the securities that they were buying, and so the idea of the SEC was to solve that informational problem, to solve an easily identifiable information problem. And the way they did it was by creating standards for how firms report financial information and for what financial information they had to report and how frequently they had to report it. Now, we could have a very long conversation about why those institutions failed, and I hope we will, or why they let us down in the most recent crisis, but the lesson for the present time, I think, for thinking about how we resolve our financial difficulties at the present time is first we have to understand what the market failures are and then we have to design institutions that take account of moral hazard, that are robust, and that leave the door open for innovation in growth in the financial sector.

And I will just say, as a final note, I don't think -- most of the policies that we've seen so far in response to the current crisis have gone in exactly the opposite direction. They have not been focused on what the market failures are. They have created massive amounts of moral hazard in the system. And I think that there is a lot to be done to steer the financial architecture in a better direction.

FREELAND: Thank you very much. I was starting to feel like I'm going to have to cut you off but you just made it under the line. And just listening to your comments and -- your comment, Dean Cooley, about these reforms creating a financial system that has been the envy of the world, I couldn't help --

COOLEY: (Inaudible.)

FREELAND: No, I couldn't help but thinking about our obsession at the FT this week, which is preparing for the G-20 summit, and I was a little late for this session because I got a call from a senior member of the president's economic team asking me a question, which doesn't happen to us very often, and the gist of his questioning of me was basically how much do they hate us -- (laughter) -- and when we get to London, how mad are they all going to be at us and how much are they going to blame us, i.e., the United States, for this current crisis? So there has sort of an abrupt shift there.

Professor Cochrane, please.

JOHN COCHRANE: Thank you. To learn, say, what the lessons are of the Great Depression, I think it's good to recognize some ways in which things are the same, some ways in which things are profoundly different, and to try to understand why things work and don't work. Otherwise you just end up fighting the last war. For example, then we had deflation that contributed a lot to the credit problems because people had to pay back with more expensive dollars. That made the banks less solvent, for artificial reasons. We went through a whole wage thing this morning without mentioning deflation. The reason wages were high is that nominal wages stayed the same and the price bubble went down.

We learned that lesson. We're not going to have deflation. That's a fundamentally different situation for everything else we're doing. In fact, as many people have mentioned, the danger now is inflation. And I would say it's a greater danger than most of the other people have said. Our danger now is a run on Treasury debt. It's not just can the Fed soak this stuff back up again, but can it soak this enormous amount of debt back up again when people don't want either money or Treasury bills or anything labeled "U.S. Government." The danger is not 1932; the danger is Argentina, a massive run from Treasury debt. And then monetary policy will not be able to do anything. You can fool around with interest rates all you want. When people don't want Treasury bills or money you're stuck.

Banks -- we had a lot of bank failures in the Great Depression. We're having them now. Ben Bernanke had a classic analysis of how the failure of banks meant no one was around to make new loans. That was excellent. It was probably right about the Great Depression, and I think it emphasizes the policy goal is new loans, not who lost a lot of money on old stuff and is unhappy about that. Unfortunately, I think we're in the danger of fighting the last war here. Bernanke has said, no large bank or financial institution will fail. We're in the business of an astonishing bailout and credit guarantee, unimagined by the Great Depression.

Things are much different than they were in the Great Depression. Now credit markets are much more important than banks, and I think credit markets are the essential problem. We didn't have asset-backed securities back then. That's where -- that's what's collapsed. Bank lending really has not collapsed, and that's the essential problem. Banks don't lend; banks originate and sell.

The system is much more resilient than it was because of deregulation. Back in the Great Depression you couldn't have branches. You couldn't have interstate banking. If the Bailey Savings and Loan goes under, there is no way that JP Morgan, financed by an equity infusion from the sovereign wealth fund of Kuwait can come in and take over and start lending. You're just stuck. Well, we're not in that situation anymore. There's a great danger of confusing banks for the banking system, and now we have a more competitive banking system. If A vanishes, B can come in and take its place. The problem really is no one wants to lend. Banks are piling up reserves.

Now, nobody in the Great Depression -- we don't -- some of our essential problems we don't have a historical antecedent for. Nobody was fooling enough to think that toxic assets were the problem or that the government, by somehow stirring up the liquidity of $10 trillion of toxic assets, was going to make the banks look all right again. This is an amazing fairy tale we've been telling ourselves for eight months now. Think of every step of the chain. Stirring the pot is going to make everything more valuable. Making everything more valuable is going to make the banks look solvent again. Making the banks look solvent again means people are going to start buying bank stocks. Banks are just dying to go and lend if only they had more equity -- it's not just going to happen. Well, that one we're inventing on our own.

My job is a finance professor so let me mention a few things about securities. Fundamentally what happed in the '20s to '30s and in the recent time to now has very little to do with the Fed. The risk premium was very low in the boom and is very high now. There's almost no economics that describes how the Federal Reserve, by monkeying around with three months of Treasury bills and reserves, can lower long-term interest rates, but absolutely no economics that says how the Federal Reserve is in charge of the risk premium, and that's what was going on. People were willing to hold mortgages, stocks, risky bonds at amazingly low premiums on the way up and now they want very high premiums on the way down. That's not something the Federal Reserve is in charge of.

Let me say something nice also about Glass-Steagall. It had many faults but its essential wisdom is that if there's something systemic that you're going to bail out, you draw a circle around that and then you say, this is not systemic and will be allowed to go under. That's what we're going to have to do, and our current Treasury plans still don't envision that. They envision we're going to let these monster businesses keep going and somehow perch a little fairy of regulation on everybody's shoulders to make sure they do the right thing. That just is not going to work.

General -- well, a last couple of general comments. Many things are depressingly the same. Policy is chaotic. Who would invest in this climate? It's not about toxic assets; it's about who wants to go in on a deal with Darth Vadar, who can change his mind at any moment? That's the uncertainty that's keeping things from getting going and that's what's slowing the rebuilding of financial markets. We're facing growth-destroying marginal tax rates, an excuse for the government takeover of large and completely unrelated sectors, class warfare, vindictive ex post taxations. This is the chance for a credit crunch -- which normally resolves itself fairly quickly -- to turn into a Great Depression. And perhaps most of all there is the danger of learning the wrong lessons; that our grandchildren will have to come back to the next meeting to say, what were the lessons -- the lessons mis-learned of the last time around?

My great hope is that the bounce-back will be quick before the quack medicine can be said to have worked. (Chuckles.) Just as we sort of -- as people think that this insane idea of fiscal stimulus -- which I'll go on with later if I get a chance -- came from Roosevelt's experience with no reason why it should work, there is a danger of thinking all of the crazy stuff they're doing now will have caused the bounce-back, if that happens, in five years, but my only hope is that it happens quickly and doesn't leave us with another Great Depression.

FREELAND: Okay, well, I'm very glad this is on the record because I love that Darth Vadar description of the government.

COCHRANE: (Inaudible) -- will pray I don't change it again.

FREELAND: My economic official who called me up this morning also couldn't resist blaming the press for all of the government's problems. I'll say that professors are even worse than the press.

Professor Geisst.

CHARLES GEISST: I guess this makes me Luke Skywalker after this? I remember when I first read the Glass-Steagall Act some time ago and the impression that I got by reading it was, I think, very much the same as Dean Cooley, the same impression he gave before. This seems to have been, at least on the investment commercial banking side, not the FDIC insurance, which is a separate issue -- the thing read very well. It was functional. It didn't actually proscribe anything, it just told you what you could do, which is unlike a lot of American law. For instance, banks were defined -- a commercial bank was defined by being able to trade in a foreign exchange, clearing functions, whatever it was, but the one thing that they couldn't do was not proscribed. They simply -- the act simply says you can't earn more than 10 percent of your revenues from a securities-related business.

That's a very polite way of saying, all you guys who have been making money for years as private bankers are now going to have to choose, which of course JP Morgan and the others did. It was probably one of the more positive things that one could actually read in a time period of 1933 to 1934. So as a result bankers knew, on both sides of the spectrum, what they could and what they couldn't do, quite simply, and over the years it seems to have worked tolerably well. We've had very few bank failures and we seem to have our greatest concentration during bad economic times. So in the '80s there were hundreds of bank failures -- there are now -- that we had at that time. But in between, given the odd scandal here and there in the banking, or the investment banking world, things worked out more or less well.

Now, the controversial part about this is something that I had to address this past summer, writing some material about the origins of the current crisis. And this, by the way, I will admit is heresy in finance to say, but bankers started to change their mind and get into securitization of asset-backed securities -- commercial bankers did. Because of prevailing finance theory they began to think of their loans as portfolio assets rather than simply loans. This wasn't something they wanted to keep on their books anymore than they were going to make these things and securitize them.

There are number of theorists for that. I think some of you all know who this is. And nobody is responsible for this; it was just something which was adopted by bankers. So it gets to be a reductio ad absurdum or nauseam when credit card companies run by banks start making credit card loans to the poor. They also start making them to undergraduate students, giving them lines, charging them interest which of course is usurious in anybody's imagination, and they simply can justify it by simply saying, why don't we securitize this? This will take the pool of securities and give it a marginally higher yield. So in other words, a loan is no longer a loan; it's now become, if you will, a tradable piece of collateral. Parenthetically, I think the anecdote that someone wrote about what undergraduate students use the credit cards for is rather interesting. Besides booze and bail, they use them for body piercing. That gives you a pretty good idea of the portfolio pool.

So the more we come into the modern period the more we drop traditional banking and become portfolio managers. Banks are creating loans which they have no intention of keeping. We find ourselves in our current problem. I think saying returning to the past is a bad deal, generally speaking, unless we return to something like Glass-Steagall, which happened to be well written. I think because it's well written and it has a decent history after it of success that it's something well worth considering again, in some or other form, with modifications.

FREELAND: Okay, well, I certainly like the idea that good writing is the key to good financial regulations. (Laughter.) The FT could not be opposed to that.

GEISST: Less argumentative.

FREELAND: And, finally, Professor Walter. We started with the Stern School and we'll conclude with the Stern School.

INGO WALTER: Good, and thank you very much. Well, I'd like to say a couple of things about the counterfactual, what would have happened had the Glass-Steagall Act never been passed. It's always nice to run the history twice and see once what actually happened and once the way things might have gone. And back in the 1980s we did a lot of academic research tracing the origins of Glass-Steagall and so forth, and one of the things that you conclude is that it was basically a mistake, a factual mistake. That is, some of the things the banks in those days -- universal banks were accused of having done, they never did. And just -- you know, these were facts, they were factoids being used to support Glass-Steagall, which actually never happened. But that's okay because the act was what it was, and when you have to legislate under pressure you do what you have to do.

So as a result we had 66 years -- almost 66 years of protection of the investment bank, the investment banking business, who were on the other side of the line, and they did what they had to do, which was basically grow their business, their origination of securities, fixed income as well as equities, trading those securities and distributing them to investors. And in the process they got extraordinarily efficient and extraordinarily creative and they started taking market share away from banks. And it's very nice to be able to trace that as commercial banking loses its role in intermediation and investment banking, or the parts of the value chain that you would call the securities value chain -- including asset management, by the way -- rises. And why does that happen? Did it happen because everybody won? From the borrower's point of view they got the lower cost of capital and they got structures that were carefully tailored to their needs, and on the investment point of view they got a higher rate of return and also a more suitable mix of assets. And so both sides were better off. One reason they were was because the securities industry was more lightly regulated and that's one of the intermediation costs.

And so what we had was kind of a vacuuming of the financial floes into the capital markets pretty much across the board, from commercial paper all the way to structured securities. And of course the banks are going to try to redress that. They were very limited in terms of what they could do under Glass-Steagall, and so we saw, back in -- probably early 1990s we saw Section 20 and Section 20 got expanded in terms of what banks could do in the securities market and so forth. And then in 1999 we had Graham-Leach-Bliley. In the meantime, these enormous what we then called full service investment banks used their domestic platform to roll out globally. For example, in 2006 the U.S investment banks in Europe, in terms of capital raising for European companies and advising on mergers and acquisition transactions in New York had 71 percent market share in terms of the actual fees. So they used their U.S. platform extraordinarily effectively to build what amounts to an enormous export industry.

Then of course the commercial banks get into the act and now they have a very different business model, which is based on a huge balance sheet and they're able to cross-sell investment banking services with lending. In some cases that cross-selling ended up as a disastrous use of capital for the firms and so on, but what it did is it changed the dynamics of the investment banking business. So instead of being able to make a living on capital raising and so forth, they increasingly -- one by one the various products on that value chain became commoditized and they moved down the -- or sort of up the value chain into more and more profitable products that continued to maintain a margin and ultimately they pushed into proprietary trading and principal investing.

So it's a little bit like -- I always call it like a toilet bowl. Things get sequentially commoditized and at the end of the day the business model is very different from being a pure financial intermediary to being, to a large extent, a positioning firm. And we see that in the current environment, both in terms of the pipeline explosions that were taken, which were a natural part of the intermediation process, and more importantly the warehousing explosions that were taken where these firms basically took those positions on the balance sheet and funded them through deposits. And I think Tom Cooley is right, of course because he's my boss -- (laughter) -- that at the end of the day the key issue has to do with the systemic dimensions of this intermediation process and how you effectively charge for the systemic risk that individual firms generate, regardless of what they're called, whether they're called hedge funds or commercial banks or investment banks.

FREELAND: Well, you've surprised me with one thing, Professor Walter, which is I thought one of the virtues of being an academic was you didn't have to be nice to your boss. (Laughter.)

WALTER: Right.

FREELAND: You guys have all been admirably disciplined in sticking to your time so I'll ask you one quick question then I'll ask everyone very quickly to respond to you. Then we will have time for 30 minutes of questions from everyone else.

So my quick question is everyone has referred a little bit -- given us a hint of their views of how the government is doing in handling the crisis today. I'll just ask one direct question, which is, would you like to see Washington dealing with the banks as we've seen it now starting to deal with Detroit? That is, direct takeover -- take out the management and reorganize the rest?

COOLEY: You want me first?

FREELAND: Yep.

COOLEY: Well, I think we are dealing with the banks the way we've dealt with Detroit. We've been bailing them out and fumbling around trying to figure out what to do rather than facing the hard decision of how do we -- are they or are they not solvent, and if they're insolvent, how do we do an orderly restructuring or transition?

Now, there has been a lot of lack of political will in Washington for dealing with this problem. Bankruptcy -- I think Bob Lucas is right; the bankruptcy laws set for dealing with systemically important institutions need work, we need more clarity, but that's a job that can be done by government. And one of the biggest problems in the way they've dealt with it so far has been the degree of uncertainty that they've created through these fumbling steps. You know, now finally we may deal with Detroit the way we should have from the beginning, which is there is a good procedure for dealing with firms like General Motors. It's called a debtor in possession bankruptcy. If you have a market failure, you may need the government to provide the debtor in possession financing, and then you restructure it. And during this whole process cars can still be made and in a few years they can emerge from bankruptcy.

Hopefully that's what we're going to do with Detroit and hopefully we'll do the same with the banks.

FREELAND: Professor Cochrane?

COCHRANE: Yeah, but not much sign of that. I mean, yes, you can see in one weekend in October we don't want to run, we don't want utter chaos, but that was six months ago and now we seem to be the government owning and running these things forever with all the inefficiencies that that involves.

Fundamentally, what is the problem with the senior debt holders losing some money? They are the ones who sign up to lose some money. In an economic bankruptcy people have this image of a crater appears. That's not what happens. What happens is the people who have stock lose everything; the people who are senior debt holders lose some money, and they're very unhappy about that and they call up everyone in Washington to stop it, but they lose some money, we reorganize, we get going. Okay, can't do it overnight in October but that doesn't mean that we have to keep these businesses as government-run forever, and once they are it's time to get out as fast as possible.

So I think -- I want to phrase it the opposite of what you said. The danger is that we'll do with the banks exactly like we've done with Detroit and just keep them bumbling along forever and ever.

FREELAND: Professor Geisst?

GEISST: I think we do have to treat them in sterner fashion than we have in the past. The one, I think, variable in that equation is the investment bankers. I think that we -- I think Washington has the commercial banking community pretty much under its thumb by now. I'm not too sure about the investment bankers. Everybody has always been worried about the investments bankers. Franklin Roosevelt, when he was the governor of New York, was worried about them -- wouldn't say a word about them before he ran for president.

These are the sorts of folks unfortunately now -- especially since they're financial engineers -- that can leave us with a time bomb sitting behind, or not tell us about the time bomb we're still sitting on, for instance how long will it actually take to work out AIG's problems? Maybe five or six years, depending on the nature of its swap portfolio.

But, yes, I do think we have to treat them roughly or sternly, with one caveat: Watch out for the investment bankers because they do have the capability to throw a monkey wrench in the system -- not that they necessarily would. It's something worth keeping one's eye on.

FREELAND: Okay. Professor Walter?

WALTER: I'm going to take a little different slant on things of the financial or the banking system as a whole. We still have about 8,000 banks, and every year we have about 400 banks which are acquired and we have about 400 banks that are created. So we've been at about 8,000 for quite a while. And that means there is kind of a vibrancy in banking. There are startups, there are small community banks that are created and so forth. And if you look at the current problems, they're very heavily concentrated at the top end of that. We're currently doing a little project on them to see what the losses are, right through the system to regional to subregional banks, community banks and so on. Many smaller banks are in far, far better condition than the major banks are.

And one of the problems with whatever gets done with respect to the too big to fail institutions, they're likely, at least as a danger, that they'll lead to further consolidation, which is arguably, to the extent that their information, asymmetries and so forth, close links to borrowers is exactly the wrong way to go. These institutions may very well end up not only too big to fail but also too big to regulate and too big to manage. And if you take those three factors together, the systemic component and dealing with that systemic component in ways that has been mentioned become even more complex.

So I would argue that the system may look fairly chaotic but it actually has in it some sources of stability.

FREELAND: Okay --

COCHRANE: Could I? This is the opposite of the Great Depression and we're supposed to be the conference on the Great Depression. I know we all like to forget about that. In the Great Depression it was the small banks out in the countryside that failed, and there wasn't competition and entry was much harder at that time and the big New York banks were okay. So we're in unchartered waters as far as that's concerned. Now, back to current events.

FREELAND: Or not. Maybe there will be Great Depression questions. Please, when you ask a question, if you could identify yourself and let me know which panelist you would like to speak to your questions.

Ma'am?

QUESTIONER: My name is Ricki Tigert Helfer, Financial Regulation and Reform International. I served as chairman of the FDIC in the Clinton administration. I dealt for seven years with the Federal Reserve in the 1980s on the sovereign debt crisis. For those who don't remember, 100 percent of the capital of U.S. banks were exposed to sovereign risk in 1983. It took seven to eight years to deal with that problem. It was dealt with by strict oversight by central bankers around the world, very slowly, very gradually because nobody wanted to close the largest banks in every economy in the world. So we have to be a little bit rational about how we deal with the banking crises today. That's fact one.

Fact two: For those who this reimposing the Glass-Steagall Act is the solution, let me tell you that the banks could essentially do everything they've done for the last 10 years, getting into trouble, if the Glass-Steagall Act were in place. And for those who think that the SEC '33 and '34 acts were the solution to all that we've been through, let me say that the SEC has only been involved in information -- significantly involved in information for investors and has not overseen the level of risk assumed by investment banks. So we have a series of, I think, misimpressions of the past.

Finally, the banking crisis of the '80s -- 1,300-plus banks failed and 1,500 S&Ls failed and were closed. There are systems under the FDIC for resolving bank failures, and the FDIC has ample authority to resolve them by keeping them open or by closing them. Continental Bank was kept open. Every bond holder lost his investment but it was kept open. When it was finally sold several years later the FDIC made money.

So, that said, with all of those facts in order, what is your solution for dealing with this banking crisis?

FREELAND: Can you pick two panelists?

QUESTIONER: I think I will pick Mr. Walter on the right and Dean Cooley. Thank you.

FREELAND: Okay.

WALTER: Well, can I comment on the first part of your question, dealing with the emerging-market debt crisis?

QUESTIONER: Uh-huh.

WALTER: Because I think, in retrospect, this was virtually a masterpiece of restructuring because what you had was you had an enormous exposure by the U.S. banks, particularly money center banks. You said it was 100 percent of capital or something like that. And that was carried on the books at 100 cents on the dollar. And as the conditions worsened in Argentina and Mexico and Brazil -- the so-called NBA (ph) problem -- everybody knew it wasn't worth 100 cents on the dollar but it was something. And it wasn't until we began to see a small market developing and mostly smaller banks who had been participants in syndicates were selling off into that market that we began to see roughly what the order of magnitude of that difference between book value and market value was. And the market wasn't very big; it wasn't very liquid. Trading spreads were enormous.

And we had one Dutch bank, Nederlandsche Midenstanche (ph) Bank, that went into the market and started making a market, and those spreads began to come down so that 50 cents on the dollar became more credible. And if you remember that Citicorp was the first one to recognize that and to take I think it was a $2 billion reserve against that exposure, which then was followed by the other banks, and that allowed then trading -- active trading in the used loan market, if you want to call it that, to evolve. And ultimately that led to a couple of innovative deals. One was done by JP Morgan for Mexico called the Azteca deal -- you might remember this -- and that led to the Brady restructure.

So if you combine that, creating liquidity, creating markets, creating a structure which allowed the losses to be shared between the countries, the banks and so on, and couple that with your very careful regulatory reforms, I think if you look back to that period it was extraordinarily instructive for what we have now, which is, again, a crashed market. We don't have buyers. We don't know what the government is going to do. Therefore, who is going to buy the assets, because we don't know what's on the downside. So I think besides the '30s we didn't learn a lot from the '80s.

FREELAND: Okay, Dean Cooley?

COOLEY: I'll just address two of the things that you raise. Understand, I'm not advocating going back to Glass-Steagall. I don't think reinstating Glass-Steagall would be meaningful. Glass-Steagall disappeared because innovation in the financial sector made it essentially irrelevant, and so the Graham-Leach-Bliley Act was just, you know, sealing the coffin of something that was already dead and largely ineffective.

Also, I agree with you that the SEC is not the solution to our problems. It solved a problem that existed in the 1930s, and it solved it well. More recently they've been part of the problem in changing the rules about how banks can calculate their capital asset ratios, which led them all to double, or more, the leverage that they held.

So I think we have to think about regulation in light of the innovation that's occurred in the financial system. Nevertheless, there is one idea, one principle of Glass-Steagall that I think is worth thinking about. They were concerned in the 1930s about having commercial depositors put at risk by other activities of banks. And the idea was that, you know, if you're the small commercial depositor, you don't know what other things those banks are doing, and they could be putting your money at risk.

And the equivalent to that in the modern financial system is that because of this tremendous integration and the growth of these financial supermarkets, we have banks that take deposits and do lots of other things. There are hedge funds, private equity funds, insurance, you name it, in the same -- all under the same tent. But an important part of the financial system is what I think of as the circulatory system, the plumbing, the clearing activities of banks. Fedwire, all these things which are executed by banks like JP Morgan and so on.

So if you have a lot of risky businesses, side by side with deposit taking businesses, and with the financial plumbing, the important financial infrastructure that has to keep working, it's very risky to have that endangered by the multiple activities that these institutions are engaged in.

FREELAND: Okay, that was such a hot question that Professor Cochrane wants a quick opportunity to answer.

COCHRANE: Well, I'm just so delighted to have someone here who actually knows something about something. (Laughter.)

So nobody wants Glass-Steagall, but there is the stuff that's systemic and that we're going to bail out: the prime brokerage custodian, ATM machines, stuff that we don't want the lights to go off. And then there's the proprietary trading desk that makes a lot of bets. Now, the heart -- as I see this, these two things cannot be in bed together. Why? Because you're funding the risk-taking by the bailout. This is just a -- I don't know if you want to call it moral hazard or the government's free put option that you're exploiting, whatever you want to call it. So I think the vision we had was, look, these things cannot be together and the more synergies there are, the more reason we can't let you guys have those things together.

The alternative is let this big thing be together and try to regulate it, but I think the lesson we just saw was that financial innovation means they're going to evade any regulation you have. You know, a lot of the lesson of the mortgage-backed -- mortgage-backed securities are great things, but a lot of the lesson of the downside was that they were, for example, writing credit guarantees rather than holding stuff on the books in order to evade capital requirements. Well, good luck staying one step ahead of the merged Citigroup. If you want to just let it be big, then regulate it.

FREELAND: Okay, we'll have to finish that conversation afterwards because I would like at least one more person to be able to ask a question. I'm so sorry. It was an excellent question.

Please, sir.

QUESTIONER: I'm John Biggs with the Stern School. I have a puzzle on a market failure that I would be interested in people commenting on. I think most of us who have had any responsibility for overseeing Wall Street bonuses and salaries feel it's a broken system and needs repair, and I think that a lot of Americans see it that way as well. However, people have tried. Jack Welsh certainly went down in flames when he tried to do it with Kidder Peabody, to change that system, but then of course Warren Buffet's attempts with Solomon also didn't work. And it's just an example but one institution can't move the system and improve it.

We don't really like the idea of Washington trying to pass laws to accomplish this. Are we ever going to be able to solve this problem? Do we need to change the antitrust laws and let Jamie Dimon get together with his counterparts in other places and work out a deal? That sort of appeals to me but I don't think that's going to appeal to many other people. But any comment? Will we ever solve that market failure?

FREELAND: To whom would you like to address that question?

MR. : Everyone.

(Laughter.)

QUESTIONER: They all have their hands up.

FREELAND: Professor Cochrane?

COCHRANE: What market failure? (Laughter.) You know, caveat emptor. Where is the -- if you want to waste your money on the 2-and-20 hedge fund manager, where I the public problem with that? The big lesson is that emptor needed to caveat a lot more, and if think they're being overpaid, don't invest. The only reason they get overpaid is because people are happy to invest in these companies.

QUESTIONER: It's a little difficult for the consumers to get together and do that, though.

COOLEY: The consumers can put their money in Vanguard instead. I mean, you don't have to put your money in a high-fee hedge fund or you don't have to put your money in bank stocks. If you think you're being overpaid, put your money somewhere else.

FREELAND: Okay, Professor Geisst, is it that simple?

GEISST: Yes, it is but for a different reason. Interesting you mentioned antitrust because there is a school of thought -- and there's not many people alive I think walking who understand that Glass-Steagall was a banking law but it was also an antitrust law. It kept the two sides -- what used to be called the concentration of financial power, it separated them, and very successfully for a very long time.

That's sort of an extreme view and it's more political than it certainly is economic or financial, in a sense, unless you're worried about the ultimate power at the end of the day. But if you take that view that that financial problem was actually an antitrust problem, I think it starts to make some sense that we can conquer this.

Getting down to the bonus thing, sure, because oversized salaries are an antitrust problem, they're not simply a moral problem or a populous problem. It can be addressed legally that way perhaps.

FREELAND: How could it be addressed legally?

GEISST: Well, if, you know, you're working for an institution which is highly regulated and you're worried about antitrust somehow or other, then you start putting a clamp, as we've tried badly to do on executive salaries so far.

COOLEY: Can I just jump in?

FREELAND: Professor Cooley?

COOLEY: I'm sorry, I have to say, when we move down the road of thinking like this, of thinking that the government has a role in fixing wages -- back to the 1930s. They were trying to -- the biggest failures of Hoover and Roosevelt was when they tried to interfere in the determination of wages and prices. They undertook acts to keep wages higher or lower or keep prices higher or lower. Once you start interfering with that margin, you know, game over as far as I'm concerned. It's not the government's role.

FREELAND: What about if the government is the majority shareholder?

COOLEY: The government as the majority shareholder?

FREELAND: But what if it can --

COOLEY: A, it could not be, but, yes, then they can give them GF powers.

(Laughter.)

COCHRANE: And that will help get the businesses closed down --

(Cross talk.)

COOLEY: That will get them closed.

COCHRANE: That's a good reason for it. Let's just close these things down.

FREELAND: Okay, I can't deny Professor Walter an opportunity.

WALTER: First of all, I think in terms of senior management compensation the system has worked pretty well. These guys got wiped out big time. So when you look across the industry spectrum in terms of top management compensation and the givebacks under adverse conditions, the financial services industry has given back probably proportionately more than other sectors. So in terms of moral hazard they've suffered. That is one thing.

The second thing is, with respect to what I call high performance risk-taking employees, I always ask my students, would you rather work in an investment bank or would you rather own stock in one, and the answer is we would much rather work in an investment bank because here you are getting a return on human capital and you take that return off the table as it comes, based on bonus pools, based on today's performance. And this gets into this whole issue of phony alpha or fake alpha, and maybe you should -- and this is a management issue, this is not a regulatory issue, and it's an issue for boards. Would you -- if you think about bonuses, how about maluses? Well, bonus and malus, they're sort of the opposite.

So maybe you should come up, as a board now, with different approaches for rewarding high-performance employees based on the longer-term revelation of their productivity, how that has to -- that's not easy to design, it's not easy to avoid getting around on the part of the employees, and you also have to recognize that this market for talent -- so-called talent in the industry is a tough one to deal with. People are free agents. People are often far more loyal to their teams than they are to the firm where they happen to be working. And maintaining discipline and getting through some sort of more balanced compensation system at that level is a difficult thing. But I think that's a fundamental problem of corporate governance and the way boards behave.

FREELAND: I like that line about so-called talent. We all chuckled but then it occurred to me that you guys are all the teachers and the producers of that so-called talent, aren't you? (Laughter.)

COCHRANE: So-called, right.

FREELAND: So maybe ultimately we should be blaming you.

Please, the woman at the back.

QUESTIONER: Patti Cohen, the New York Times. It seems that whatever the administration, the too big to fail argument is out there as this threat forcing an administration to act, and I'm wondering if any of you basically would argue let the two big institutions fail ultimately, and the bankruptcy system deal with that, or is it really that they're just too large and there's no alternative?

FREELAND: Okay, I want to get in a few more questions so I'm going to assign that question only to Professor Cochrane.

COCHRANE: Oh. (Chuckles.) Too big perhaps to fail catastrophically overnight but not too big to fail over a period of a couple of months. Maybe too big to go into bankruptcy court because senior debt holders have certain rights in bankruptcy court to grab assets that can cause problems in the system but certainly not too big to have the economical equivalent of failure where the senior debt loses money, the equity loses money, the operations get a new name plastered on the front of the building and keep going. We've got to do that sooner or later.

FREELAND: Okay. Please.

QUESTIONER: (Off mike) -- a question for Professor Cochrane. With changes and the fluidity in economic dynamics that Dean Walters talked about, and the internationalization of finance, do you think we need to redefine what systemic is? And if you do, what criteria would you advise?

COCHRANE: Well, I would love for someone to define it in the first place, especially, you know, coming out of the government who's, you know, said, oh, the financial markets will fail but hasn't really told us why. I mean, for a trillion dollars of my money I've got 5 minutes. You know, you can let us know exactly what the disaster will be if AIG goes down. So I think defining it at all is a problem, let alone redefining it. So I'll just say that's a great question.

WALTER: Can I just tag onto that? We try to make a list of systemic institutions to find out who is inside the tent and who is outside of the tent, just off the top of our head, and the question is, what criteria or what filter are you going to use? Obviously nobody wants to be inside the tent because they're going to be subject to special attention. So one is size, and you can measure size in different ways. Another one might be complexity. Another one might be the rate of growth. And the one we have been dealing with is, are they part of the network?

You can have a relatively small institution -- Bear Stearns is a good example -- which would not meet the other criteria but is a node in the network which its failure brings major damage to the rest of the network. If you can come up with some criteria which are measurable, trackable, practical, then you can define what the tent is, but we're still very uncertain as to what kinds of institutions should be subject to either "special taxation," in quotes, or special regulatory attention.

COCHRANE: Really only the last one, I would say, counts. In the language of economics you need an externality. You need my failure somehow to affect you in a way that you didn't know about -- you weren't expected to monitor me -- and it's going to cause you some problem. You know, if my house burns down that means yours catches on fire. That's what systemic means, and it's not clear -- just big doesn't mean systemic. It's not clear how any of this stuff means systemic.

FREELAND: Yeah, we reporters even have a shorthand for that -- too connected to fail -- (laughter) -- which is the one we've started to use for this crisis.

Please, sir?

QUESTIONER: Jim Butkiewicz, University of Delaware. I've read -- and I take it that this is true -- that the president and Paul Volcker are looking for other models for our financial system and one model they're looking to, according to this report, was Canada. The Canadian financial system is very stable but if we had a Canadian model we would have a few institutions, all of them would be huge because there's 10 banks in Canada -- if we had 10 banks only in the United States that would be a very huge set of institutions -- and they deal in all sorts of products: investment banking, insurance and the whole gamut. And I'm just curious to what any of you think about a model like that for the United States. Are there some lessons from Canada, or would that create more problems?

FREELAND: Any Canadian experts up there?

COOLEY: A cozy oligopoly can look stable for a long time.

WALTER: Yep.

FREELAND: I did actually spend an hour with the Canadian prime minister this morning. He came into the FT, and he was very -- I'm Canadian myself so I'm allowed to say that one of our national vices is smugness -- (laughter) -- and we're all feeling quite smug at the moment. It's rare that we get to really strut on the global financial stage. And the prime minister did in fact brag a little bit about the stability of the Canadian banking system, the only G-7 country that hasn't had to bail out its banks, et cetera, et cetera. He thought that there were two things about the Canadian system that had made it work. One was national regulatory oversight, and the other thing that he was very excited about was looking at overall leverage when looking at the banking system.

The other thing he said, which you can read about in the FT tomorrow, which I thought was dangerously hubristic is he's very keen that Canada's well-capitalized banks should now go forth and buy up the world banking system. (Laughter.) So we sort of felt that could be a banking crisis in the making a decade from now.

Please. And I think that's going to have to be our last question.

QUESTIONER: So what I want to know is just how toxic are those assets? So here's why I ask this question: The Home Owners' Loan Corporation that they established in the '30s, they had 40 percent of their loans were more than three months in advance and three years later they had to foreclose on 20 percent. If you had evaluated them the way we're evaluating Fannie and Freddie today, they make Fannie and Freddie look like gilt-edged stocks. And so what do you think? How bad are the various assets that we're talking about in this toxic pool?

FREELAND: Okay, maybe each one of you can give me a quick answer on how -- the toxicity level of the toxic assets. Professor Walter?

WALTER: Forty cents on the dollar.

COOLEY: Forty cents on the dollar? I mean, the question was not how bad they are but is there some magic by which they're obscured and illiquid and nobody really knows. I know people in this market that say, yeah, these are worth 40 cents on the dollar. The banks say, if I sell that to you at 40 I've got to mark down everything else and then I go out of business. And so we say frozen markets; there's no such thing as a frozen market. They see 40 cents on the dollar is the bid; I don't want to sell, so nothing happens. The idea that there's something mysterious here I think just doesn't cut it.

COOLEY: I agree with that. I don't think it cuts it, but I do think -- I will say this, that people are going to make a lot of money buying those assets because they can buy them now with a bit of leverage thanks to Uncle Sam -- thanks to you and all the rest of us.

GEISST: You know, the difficult thing about this is that if a toxic asset is an asset-backed security, a collateralized debt obligation which has part of its cash flow prevented by a credit default swap, then I give up. I wouldn't begin to tell you what that thing is worth. My guess is that, looking at AIG, it's probably less than 40 cents on the dollar.

Nobody in their right mind in the investment world -- professional investors, pension funds, insurance companies -- 15 years ago would have bought anything based upon a derivative. In fact, they were prohibited from doing it. We slipped this one under the system. So I think it's a good question -- maybe 10 cents on a dollar just because it would have to have some value.

COCHRANE: But 40 cents on the dollar at today's very high risk premium for everything that's risky -- I mean, 40 cents on the dollar, you're going to make money. This is in some sense the mother of all buying opportunities in here somewhere because there's high-risk premiums in everything people want to invest in.

FREELAND: And I think Professor Cooley made the essential point that the price does depend on how expensive the money is that you're borrowing by that asset, and Uncle Sam is very generously offering to underwrite that.

I want to thank you all for a really excellent -- (applause). Thank you very much. And thank you for some terrific questions. I learned a lot, maybe more about today than the 1930s. Thank you very much.

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