[This review was published as a book review article, Sheila Bair on The Great Recession, in the Winter 2012

issue of The Journal of Social, Political and Economic Studies, pp. 533-542.]

Book Review Bull by the Horns: Fighting to Save Main Street from Wall Street and Wall Street from Itself Sheila Bair Free Press, 2012 This book deserves a place beside Neil Barofskys Bailout: An Inside Account of How Washington Abandoned Main Street While Rescuing Wall Street (reviewed in the Fall 2012 issue of this Journal) as an independent, commonsensical appraisal of the Great Recession, its causes, the response to it, and its aftermath. While Barofsky occupied a perfect observation-post as the Special Inspector General of the bailout program, and brought to it a rare tough-minded objectivity, Sheila Bair brought those same qualities to her five year term as chairman of the U.S. Federal Deposit Insurance Corporation (FDIC) under Presidents George W. Bush and Barack Obama. She was appointed to the post in June 2006 and continued in it until July 2011. Bair grew up in a small town in southeastern Kansas, where her father was a surgeon. Her education was at the University of Kansas, from which she earned a bachelors in philosophy and a JurisDoctor degree in the law school. Senator Robert Dole hired her as legal counsel, and here we run into some things that are not explained by her resume: she quickly demonstrated a singular capacity for leadership and an expertise in financial regulation. These were in evidence when she went on to serve as a commissioner and then acting chairman of the Commodity Futures Trading Commission under the first President Bush, continuing under President Clinton. Along the way, she served as Assistant Secretary for Financial Institutions in the U.S. Treasury Department, as Senior Vice President for Government Relations of the N.Y. Stock Exchange, and as a professor of financial regulation at the University of Massachusetts. Without intending to diminish this reviewers home state of Kansas in any way, we can say that this was pretty good for a small-town Kansas girl. Whereas Barofsky started as an Obama supporter but quickly demonstrated his intellectual detachment and personal strength that impelled him to call the shots about the bailout as he saw them, Bair provides a mirror image from the other side of the political spectrum: she is a conservative Republican who has held fast to the principles she grew up with in Middle America without following either the party or the movement into the various ideological tangents that have come to absorb them. This refusal to embrace those tangents puts her in the same class with Barofskys independence and personal strength. When we speak of Bairs resistance to ideological tangents, one of the things we have in mind is her calling the deregulatory dogma that had infected Washington for a decade, championed by Democrat and Republican alike a serious disease. The fashionable view that markets are selfadjusting mechanisms that inherently discipline themselves is for her a delusion. Her perception that what America now has is crony capitalism identifies her with the earlier ideal of free-market individualism as distinct from the prevailing marriage of big money and big government. And when she considers ridiculous the rationalization that actors in financial markets were driven to greed and excessive leverage because government failed to restrain them, she shows that she hasnt joined the stream of

libertarian thinking that says everything is governments fault.1 Bair has strong convictions, but she is nobodys disciple. Groupthink, she says, is exactly what led us into the crisis. The book is told as a personal narrative of Bairs years in office, and this involves much discussion of policy issues she confronted. This makes it particularly valuable for those who have a serious interest in the United States (and the worlds) economic and financial systems. Necessarily, one function of the book is to make an historical record that will give an account of Bairs role, as she sees it, for future economic historians. Since she had many points of divergence, and considerable conflict, with President Obamas Secretary of the Treasury Timothy Geithner, whom she saw as primarily interested in protecting the big banks, fair-minded readers will necessarily want to keep an open mind until Geithner is out of office and has written his own memoirs. There are a number of features of her book that deserve individual attention: 1. What the response to the crisis should have been. Her preferences about what should have been done to address the financial crisis differed considerably from what she saw as the generous bailout policies pursued by the successive Secretaries of the Treasury, Henry Paulson under George W. Bush and Timothy Geithner under Barack Obama. Rather than treating the massive banks and financial institutions indulgently, she would have imposed discipline on profligate financial institutions by firing their managers and forcing them to sell their bad assets. She preferred winding up the likes of Citi, Merrill and AIG through a streamlined resolution process similar to that used by the FDIC to clean up after the U.S. savings and loan debacle a few years ago. (With the long experience of the FDIC in mind, Bair believes this process is in many instances considerably more efficacious than bankruptcy proceedings, a judicial rather than administrative process that often involves years of legal wrangling.) In connection with Bairs opposition to bailouts, there is a significant omission in her discussion. She makes that opposition clear, and discusses important alternatives. But at no point does she speak directly to the major premise that underlay the sense of panicked urgency that was felt by Federal Reserve Chairman Ben Bernanke and by Paulson and Geithner at the height of the crisis when one major financial institution after another teetered on the edge of collapse. Their premise was that a failure by the mega financial institutions would produce a cascade of falling dominoes, not just in finance but in the real economy. Whether or not this would have been so deserves explicit discussion. So far as this reviewer knows, it has received no detailed explication by either the pro-bailout policymakers or their opponents (although he hasnt reviewed all of the vast literature). Bair is not alone in leaving the effects to inference. Of paramount importance to her was to address the mortgage crisis that lay at the heart of the distress. To do that, what was needed, as she argued at the time, was a systemic program that would address the defaulting mortgages easily and simultaneously without invoking what she saw as an impossibly cumbersome process of renegotiating each of the millions of loans one at a time. This called for an answer that seemed obvious: to eliminate the reset [i.e., the upward jump in interest rates that would occur under the many adjustable rate mortgages] and simply extend the starter rate. In other words, convert the loan into a thirty-year fixed-rate mortgage. When her advice went unheeded, the Obama administration embarked on what she accurately foresaw as an utterly insufficient, incompetent and even corrupt one-at-a-time mortgage modification program which has struggled lamely over several years, leaving the economy handcuffed and millions of homeowners suffering.
1

This view that actors in a market economy are justified in doing whatever they wish if regulators dont bar them from doing so appears at least superficially to be an extension of free-market thinking. It runs counter, however, to the classical liberal premise that government can to be kept small precisely because a moral culture exists that channels behavior in ways that are consistent with a workable market economy. One (but only one) of the sources of the recent ideological turn toward an unrestrained pursuit of self-interest is Ayn Rands exaltation of the virtue of selfishness. Supporters of a free society featuring a market economy, limited government, the rule of law and associated factors find much that is inspired in Rands thinking, but would do well to see, at the same time, that her philosophy is in many ways widely divergent from classical liberalism.

2. Avoiding the crisis in the first place. Her positions on what should have been done to meet the crisis blend, of course, into her thinking about what needed to have been done to prevent the crisis. She writes that the financial crisis could have been easily avoided with a few commonsense measures. First, she cites the need for sufficient capital requirements so that stockholders and unsecured creditors would have skin in the game and be motivated, by the threat of losing their own money, to keep a careful eye on the amount of leverage and risk taken on by their respective institutions. Second, there needed to have been meaningful lending standards for home loans, something that the Federal Reserve had the authority to impose but did not. (Indeed, we can add that there had been several years of drift away from lending standards induced by politics and by an ideologically-driven preference for helping the poor and minorities by providing them with unsustainable mortgage loans help that proved illusory when the housing market and their debt burden blew up in their faces.) The collapse of lending standards had led to millions of loans being made on the most incredible basis, such as without income verification and with negative amortization (monthly payments that werent enough to reduce principal). This relied on home values always continuing to rise, which would allow borrowers repeatedly to refinance (and, not coincidentally, would generate abundant fees for the lenders). It was these loans that caused the toxicity of the securitized bundles of loans which were sold to investors all over the world. There is much more to it, of course, than we can explain here; readers of Bull by the Horns will find the more complete explication told lucidly by Bair as she describes how the bundles were sliced into tranches and then resliced again to produce collateralized debt obligations (CDOs) formed out of the riskier tranches, with the credit rating agencies blessing so much of it with AAA ratings because, after all, mortgages had had a low default rate in the past. An important feature of all this was that the originators of the home loans were again among those who kept no skin in the game, since they were paid up front and would suffer no losses regardless of how defective the product might be. Third, she points to the enormous pre-crisis growth of the credit default swap (CDS) market to the unbelievable sum of $62 trillion by the end of 2007. Despite their esoteric name, CDSs are a form of insurance contract by which a company like AIG guaranteed vast amounts of debt against default, even insuring speculators who owned no insurable interest in the debt and would realize pure profit from the insurance if there were a default because they were not the ones who were owed the debt. The result, Bair writes, was that hundreds of billions of dollars worth of mortgage losses translated into trillions of dollars of trading losses. This could have been avoided, she says, if there had been adequate controls on CDSs and if the historic insurance-law requirement that the buyer of insurance have an insurable interest had not been abandoned. 3. Reforms looking toward the future. Bair favors the Federal Reserve and FDICs using the authority given to them by the Dodd-Frank (financial reform) Act to require the largest institutions to restructure themselves into a manageable number of distinct operating subsidiaries. This would undo the tangled web that has been a feature of the modern financial system, where financial institutions have created thousands of different legal entities, frequently to evade regulatory or tax requirements. Even though she has a different take than others about too large to fail when she says that the problem is really one of complexity and interconnectedness rather than of size, she is sympathetic to the school of thought that argues that the megainstitutions should be broken up by Congress now. That is a line of thinking akin to Woodrow Wilsons New Freedom preference, voiced a century ago in the presidential election campaign of 1912, for breaking big business into smaller, competitive units. Her reason for only being sympathetic to the break-up idea is founded in political realities: she believes Congress does not have the political will to take that step. That leads her to settle for the restructuring just mentioned. She would put an end to the game of musical chairs that has seen people go from top roles in the major financial institutions into leading positions in government and then back again. (This is part of some much larger issues, such as of government agencies becoming captive to the industries they regulate, and of personnel going from Congress or the executive branch into lobbying or into top jobs

with corporations that have been under their purview, a process that lends itself greatly to the crony capitalism that Bair abhors.) Bair argues that there should be a lifetime ban on regulators working for financial institutions they have regulated. Other reforms she advocates include reducing the tax incentives that now encourage high leverage (borrowing) and risk-taking both by businesses and home purchasers. Under current law, interest paid on debt is fully deductible, while dividends paid to shareholders are not. This is one of the reasons why it is cheaper for a financial institution to fund itself with debt than equity. (Recall that she believes that sufficient capital i.e., equity is a key to a sound system.) The full deductibility of interest paid on a home loan similarly encourages home owners to get cash by refinancing their homes in preference to getting consumer loans, upon which the interest is not deductible. More broadly, Bair feels that government should not be in the business of promoting home ownership, a view that leads her to favor doing away with the mortgage interest deduction (or, if politically necessary, replacing it with a conditional tax credit) and disbanding the giant quasi-federal mortgage financing agencies, Fannie Mae and Freddie Mac. The Dodd-Frank Act was signed into law in July 2010. As we have seen, Bair strongly favors the provisions for streamlined resolution of failing institutions and for restructuring, but she cautions that the reforms are far from complete, since virtually all of the reforms in the new law relied on agency rule making for implementation, with the result that the industry redirected its army of lobbyists to the rulewriting process. Even as to the law itself, many of its provisions were watered down as a result of industry lobbying and, in some instances, at the behest of Timothy Geithner and his surrogates. A major omission is that the new law hasnt limited credit default swap insurance to situations in which the purchaser of the insurance has an insurable interest. 4. A political disconnect: the tail wagging the dog. Bair does not herself make an explicit point out of it, but some of the things she mentions leads one to think that President Obamas Secretary of the Treasury established a de facto policy that contradicted the pronouncements and rhetoric coming from the president. Instead of the presidents setting the real policy, he articulated one thing while allowing something else to be done by his chief economic officer; hence, it would seem that the president permitted the tail to wag the dog. One instance is that Bair says that although I think the White House truly wanted to end bailouts Treasury and the Fed were still pushing for regulators to have maximum flexibility to do future bailouts. Geithner even issued a white paper that essentially ratified them [bailouts] as legitimate and empowered the secretary of the Treasury to carry them out unilaterally in the future. Another instance arose in the fight over whether a bailout fund should be created by assessments against the big institutions: Tim [Geithner] was obviously teaming up with Senate Republican partisans, who were overtly using the bailout-fund rhetoric to criticize his boss, President Obama. Why? The fund was going to be paid for through an assessment on large financial institutions. And perhaps most important of all, when it came time after the crisis to enact major reforms, Obama left the legislative battles to him [Geithner]. Bair says I couldnt think of one Dodd-Frank reform that Tim strongly supported. In fact, he worked to weaken or oppose them. 5. Some important questions Bair does not discuss. Bull by the Horns makes no pretension of being an exhaustive treatise on economic or financial theory, so it is beside the point to say that there are many things, however important, that Bair doesnt explore. This reviewer has just thumbed through his book The Great Economic Debacle and Beyond,2 which features his reviews of books by seventeen prominent economists about the financial situation. Those books contain many suggestions about possible reforms, including several that correspond to those that Bair favors and others that she does not touch upon. Readers will, of course, want to explore that other literature.

Published in 2011 by the Council for Social and Economic Studies as No. 34 in its monograph series. It is available through this Journal. The book may be accessed free of charge on the following web site: www.dwightmurphey-collectedwritings.info

Bair has held closely to the narrative of her years in office, but it is surprising that her discussion of policy is presented without reference to the immense body of theory that is developed in economic and financial literature. One can surmise that her own study and that of her staff at the FDIC took a great deal into consideration that she does not mention, which makes surprising the impression that policy-making in government takes place in something of an intellectual vacuum devoid of academic or other professional input. Another omission may point to a proclivity on Bairs part, despite the strength she showed by standing athwart the views of others on so many things, to stay in the mainstream of what is politically correct. She hardly mentions the Community Reinvestment Act and the long history of punishing lenders for discriminating against minorities through red-lining or other ways a lender might use to avoid making economically unsound loans. It is as though the collapse of lending standards happened coincidentally, without a push from long-standing ideology and politics. In his dissenting opinion filed with the report of the Financial Crisis Inquiry Commission, Peter Wallison did have the hardihood to bite into that. He dealt with a sensitive subject that Bair avoids. The Great Recession, as it is now called, should ideally be an occasion for rethinking quite radically the entire institutional (as well as ideological, cultural and moral) infrastructure of capitalism. In the 1930s, several hundred economists joined together in backing the Chicago Plan to do away with fractional reserve banking, in effect advocating a profound change in the American banking system.3 The Plan was never put into effect, in part because the American peoples attention was deflected from the Depression by the onrush of World War II. Bairs job as chairman of the Federal Deposit Insurance Corporation positioned her, of course, at the very heart of the fractional reserve system of banking. It isnt surprising that she would implicitly accept the system she was working within. If at some time she turns her mind toward examining its premises, she should have much to bring to the discussion. We shouldnt conclude without another word of commendation, and without the caveat we make in so many of these reviews that the book contains much more than we have been able to touch upon here. Bull by the Horns deserves every serious readers attention. Dwight D. Murphey

The Chicago Plan is discussed in detail in this reviewers article Capitalisms Deepening Crisis: The Imperative of Monetary Reconstruction in the Fall 2011 issue of this Journal. The article is available as A105 (i.e., Article 105) on the web site referred to in Footnote 2 here.