Case analysis: The Great Recession, 2007-2010: Causes and Consequences

This week, you will have an opportunity to review the Great Recession of 2007-2010 along with the causes and consequences of this event. In addition to the requirements for the analysis of a case study covered below, please specifically answer the following questions:

1. Should financial institutions be prevented from becoming too big to fail? What criteria should be followed in making such judgments?
2. Should consumer decisions concerning loans be regulated?
3. Should governments use public money to bail out failing institutions?

Required for the Analysis of a Case Study:

Provide a 4?6 page case study analysis using the following format:

Format: Must include these headers

1. Title page
2. Company and Situation: Describe the Company and Situation
   • To begin your case study analysis, discuss the critical incidents that have contributed to the current position of the company. Here you must identify the most important facts surrounding the case.
   • Does the problem or challenge facing the company come from a changing environment, new opportunity, a declining market share, or inefficient internal or external business processes?
3. Strengths, Weaknesses and Alternatives: Identify Strengths and Weaknesses as well as Alternatives
   • Examine the value creation functions of the company and specify alternative courses of action.
   • List the courses of action the company can take to solve its problem or meet the challenge it faces. What changes to organizational processes would be required by each alternative? What management policy would be required to implement each alternative?Remember, there is a difference between what an organization ?should do? and what that organization actually ?can do.? Some solutions are too expensive or operationally difficult to implement, and you should avoid solutions that are beyond the organization?s resources. Important: Identify the constraints that will limit the solutions available. Is each alternative executable given these constraints?
4. Implementations: Analyze ImplementationsThis portion of the case study analysis requires that you identify and analyze the structure and control systems that the company is using to implement its business strategies. Evaluate organizational change, levels of hierarchy, employee rewards, conflicts, and other issues that are important to the company you are analyzing.
5. Recommendations: Make RecommendationsThe final part of your case study analysis should include your recommendations for the company. Every recommendation you make should be based on and supported by the context of your case study analysis, i.e., what you have already written.
6. Additional Questions: Answer the additional questions as shown below. Each question should be placed in bold as a header:
   1. Should financial institutions be prevented from becoming too big to fail? What criteria should be followed in making such judgments?
   2. Should consumer decisions concerning loans be regulated?
   3. Should governments use public money to bail out failing institutions?
7. References: Reference page

Access the case study template formatted in APA.

The case analysis should be a minimum of four pages, double-spaced. Check for correct spelling, grammar, punctuation, mechanics, and usage. Citations should use APA style.

Your analysis of this case and your written submission should reflect an understanding of the critical issues of the case; integrate the material covered in the text and present concise and well-reasoned justifications for the stance that you take.

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For the exclusive use of W. Schmidt, 2016. S w 910M08 THE GREAT RECESSION, 2007-2010: CAUSES AND CONSEQUENCES1 Danielle Cadieux wrote this case under the supervision of David Conklin solely to provide material for class discussion. The authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors may have disguised certain names and other identifying information to protect confidentiality. Ivey Management Services prohibits any form of reproduction, storage or transmittal without its written permission. Reproduction of this material is not covered under authorization by any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Ivey Management Services, c/o Richard Ivey School of Business, The University of Western Ontario, London, Ontario, Canada, N6A 3K7; phone (519) 661-3208; fax (519) 661-3882; e-mail cases@ivey.uwo.ca. Copyright 2010, Ivey Management Services Version: (A) 2010-01-15 INTRODUCTION A recession in the U.S. economy began at the end of 2007. Concerns deepened as an epic financial crisis shattered business and consumer confidence. By the fall of 2008, the United States was in the midst of the worst recession since the 1930s, and major financial institutions were on the verge of bankruptcy. The financial crisis and recession spread around the world. Many saw a risk that the global financial system might collapse, perhaps precipitating a repetition of the lengthy economic devastation of the Great Depression of the 1930s. Governments reacted by creating huge stimulus packages that greatly increased national deficits and debts and by loosening monetary policies by dropping interest rates close to zero, which hugely expanded the money supply. As part of their efforts to save the financial system, governments also offered bailout packages to banks, including loans, guarantees and equity. By the fall of 2009, the crisis had stabilized, and the appearance of so-called \"green shoots\" gave the promise of recovery. By 2010, analysts were able to put the financial crisis in perspective and to raise questions about its causes and consequences. Of particular concern was whether new regulations might be needed to prevent a recurrence and whether some of the tighter regulations should be international in scope. A related concern was whether such regulations, which applied to banks, should also be applied to non-bank financial institutions. Governments were also trying to determine how to exit the unique fiscal and monetary positions that now seemed to have placed their economies at risk of ongoing deficits and future inflation. 1 This case has been written on the basis of published sources. This document is authorized for use only by William Schmidt in 2016. For the exclusive use of W. Schmidt, 2016. Page 2 9B10M008 CAN NEW LAWS PREVENT UNETHICAL DECISIONS? On November 18, 2009, the Financial Times featured a report on page 1 concerning an apology from a leading financial institution, Goldman Sachs: Lloyd Blankfein, Goldman's chief executive, told a corporate conference in New York that the bank regretted taking part in the cheap credit boom that fuelled the pre-crisis bubble. \"We participated in things that were clearly wrong and have reason to regret,\" Mr. Blankfein said. \"We apologize.\"2 All free market economies are subject to fluctuations in aggregate demand, and underlying this recession were numerous traditional business cycle forces. However, this financial crisis and recession were made more severe by what some had termed a \"legal fraud,\" in which the mortgage providers offered mortgages to borrowers who could not afford them, often including terms whereby interest rates increased over time. These mortgage lenders must have realized that they were involved in a legal fraud, in which many borrowers ultimately would not be able to pay. The mortgage lenders sold their \"subprime\" mortgages to banks that securitized them and then sold them to other investors under the pretense that the new financial instruments were safe investments. Meanwhile rating agencies place unrealistically high ratings on these instruments, depending as they did on satisfying the banks in order to be given this task. Although many involved in this legal fraud did not break the letter of the law, the long chain of participants no doubt must have realized that the bubble would burst, and millions of people would be hurt. It appears that many participants simply did not care about the interests of \"the innocents\" who would be hurt, including their own shareholders. Many bankers must have known they were involved in a legal yet fraudulent activity in which they were fooling the ultimate investors. The providers of insurance in case of default also should have known they could not honor their commitments in the event of a collapse in the markets for the collateralized debt obligations (CDOs). This perspective emphasized the new importance of corporate ethics and corporate culture in decisions that did not involve an explicit violation of the law. A central issue in this chain of misinformation concerned the nature of both the general business culture and each bank's specific corporate culture that permitted employees to engage in unethical activities. Regulators have limits to the degree to which they can prevent all frauds. As long as corporations are willing to allow such behavior by their employees, such financial disasters will inevitably recur. The special role of CDOs rested on the reality that a pile of mortgages cannot be divided into different tranches, each with specific differences in risk that are reflected in their interest rates. If investors are offered a portfolio of real estate mortgages, can they securitize the portfolio and determine the appropriate differences in interest rates? Inevitably, such analysis is not possible with any degree of accuracy or by relying on the foundation of any financial principles. Bankers must have also recognized this situation, but they did not care about the inevitable losses that others would suffer. The fraud was legal. Some U.S. analysts and politicians did see danger in the buildup of subprime mortgages and in the vulnerability of portfolios in institutions such as Freddie Mac (the officially adopted abbreviation for the Federal Home Loan Mortgage Corporation, or FHLMC) and Fannie Mae (the familiar name for the Federal National Mortgage Association, or FNMA). The hesitancy in intervening can be criticized. Some observers pointed to the relationship between this hesitancy and contributions to the political campaigns of U.S. Members of Congress. Yet the U.S. public philosophy emphasized the importance of making home 2 Francesco Guerrera, \"Goldman Apologises For Crisis and Pledges $500m to Small Business,\" The Financial Times. November 18, 2009, p.1. This document is authorized for use only by William Schmidt in 2016. For the exclusive use of W. Schmidt, 2016. Page 3 9B10M008 ownership a realistic dream for all Americans. The U.S. income tax provisions that allowed the deductibility of mortgage interest gave everyone an incentive to maximize their mortgage. In the securitization process, the ultimate purchasers of CDOs had no way to understand the risks they were assuming. Clearly, the ultimate purchasers significantly underestimated the risks they accepted in expectation of high rates of return on these investments. Although some commentators, even Alan Greenspan (the recent chairman of the Federal Reserve until his retirement in January 2006), believed that securitization improved the functioning of capital markets and gave investors new opportunities to choose their desired combination of risk and return, in fact the inability of the ultimate investors to understand the risks created an unsustainable component of the financial system. However, when this component of the financial system collapsed, the entire financial system was severely damaged, to the degree that financial institutions became insolvent and those holding the securitized assets lost much of their investments. As a result, the destruction of public confidence substantially reduced consumption and investment. As part of the securitization process, many banks came to rely on credit default swaps, and this hedging against default created a complex web of counterparty relationships with a concentration of risk in a few very large firms (such as American International Group, Inc., or AIG) that created huge systemic damage when they failed. Financial institutions created a wide variety of securitized investments based on many types of assets, such as commercial property, credit card debts and commercial loans. Most of these investments lacked adequate transparency and information for investors to be able to understand the risks. In Canada, $32 billion of \"asset-backed commercial paper\" (ABCP) suddenly froze in 2007, leaving investors with illiquid securities. By 2009, Canadian regulators had imposed $130 million in penalties from banks that had sold these investments and had led a restructuring that promised hope for investors. In a speech presented at the United States Military Academy at West Point, Jeffrey Immelt, General Electric's chief executive, was severely critical of the current era of business management: We are at the end of a difficult generation of business leadership . . . tough-mindedness, a good trait, was replaced by meanness and greed, both terrible traits . . . . Rewards became perverted. The richest people made the most mistakes with the least accountability.3 CAN THE IMPACTS OF INTERNATIONAL IMBALANCES BE CONSTRAINED? The financial crisis arose apart from the global imbalances that had been building for many years, but these global imbalances added to uncertainty in the recession and made the recovery policies more complex. The global imbalances created a dangerous ongoing situation, in which capital volatility could suddenly increase with substantial impacts on exchange rates and flows of trade and investment. In particular, the huge U.S. fiscal deficit and balance of payments deficit meant that the exchange rate of the U.S. dollar could fluctuate rapidly and substantially. Some countries, especially China and the major oil producers, exported far more than they imported, and so they accumulated enormous volumes of foreign exchange. They channeled these large volumes of savings into bonds in a few of the developed countries, especially the United States. Because of its very low savings rate, the United States came to depend on these capital inflows to maintain low interest rates, but these imbalances placed the United States at risk of possible capital outflows. China's decision to 3 Francesco Guerrera, \"Immelt Rues 'Terrible' Executive Greed That Fuelled Inequality,\" Financial Times, December 10, 2009, p. 1. This document is authorized for use only by William Schmidt in 2016. For the exclusive use of W. Schmidt, 2016. Page 4 9B10M008 undervalue its currency, in an effort to stimulate exports and jobs, added to this situation of international imbalances. Furthermore, the huge increase in commodity prices, together with the possibility of periodic declines, remained an ongoing threat to international imbalances and exchange rates. In addition, sophisticated investors were able to borrow in countries with low interest rates and to lend in countries with higher interest rates. The growth of this \"carry trade\" meant that changes in the differences in interest rates among countries could rapidly lead to changes in capital flows that could alter exchange rates. The global attempts to revive the economy created a new type of imbalance for many countries, namely, enormous increases in national debts and money supplies. As a result, some analysts felt that rapid inflation could develop in a couple of years. The solutions for the recession might have built into the global system the risks of a new crisis. Could new forms of international co-ordination of fiscal, monetary and exchange rates policies limit the impacts of global imbalances and sustain aggregate demand at noninflationary levels? HOW CAN RISKS ACCOMPANYING HUGE FISCAL DEBTS AND MASSIVE MONEY SUPPLY EXPANSIONS BE MANAGED? Faced with rising unemployment and decreases in gross domestic product (GDP), governments throughout the world adopted Keynesian fiscal policies that greatly increased government spending, often on infrastructure projects. Governments hoped that these added expenditures would have a multiplier impact on aggregate demand in order to counteract the private sector's reluctance to spend as a result of the loss of consumer and business confidence. Some governments also reduced taxes, again in hopes of stimulating private sector spending. At the same time, governments lowered the statutory interest rates that they could control, such as lending rates for overnight loans from their central banks to commercial banks and interbank loans. By purchasing bonds from the private sector, governments also increased their country's money supply, which, in turn, raised the price of bonds and lowered interest rates. In many countries, this process of purchasing bonds was extended to also include other assets, which added to this \"quantitative easing.\" By 2010, many nations faced the challenge of how to \"exit\" the stimulus they had created in their fiscal and monetary policies. Some analysts feared that the stimulus was only temporary, and that the infrastructure spending would come to an end before a self-sustaining recovery could take hold. Perhaps new stimulus packages might be necessary. An exit too early might shove the economy back into recession. Some observers pointed to 1937 as a situation where a too early exit had resulted in a disastrous effect. The deficits and debt had become enormous, and the money supply expansions were also huge. Furthermore, each nation's tax base had been severely damaged. Peak-to-trough falls in GDP ranged from 8.4 per cent in Japan, to 6.7 per cent in Germany, 6.5 per cent in Italy, 5.9 per cent in the United Kingdom, 3.8 per cent in the United States and 3.5 per cent in France. In the United States, the federal debt as a percentage of GDP had increased from 35 per cent in the 1990s to a projected 100 per cent by 2012. Projected fiscal balances (less interest payments) for 2010 as a percentage of GDP ranged from -7.8 per cent for the United Kingdom to -3.7 per cent for the United States, -2.1 per cent for France, -1 per cent for Canada, -0.4 per cent for Germany, with Italy expecting a positive balance of 1.0 per cent. Interest payments would add substantially to these estimates of fiscal This document is authorized for use only by William Schmidt in 2016. For the exclusive use of W. Schmidt, 2016. Page 5 9B10M008 deficits. Any increase in interest rates would compound these problems. Meanwhile, central banks had increased the money supply. In the United States, for example, money supply (M1) increased by more than 16 per cent in 2008 alone, in spite of the money supply contractions caused by financial institutions' reducing their total loan value, and customers limiting their borrowing. How could each nation manage these enormous deficits and the consequent buildup of debt without experiencing inflation or risking another recession if taxes were raised and if monetary policy were tightened? While some banks were operating with smaller reserves than regulations required, nevertheless the U.S. banking system as a whole now had more than $1 trillion in excess reserves. With economic recovery, these excess reserves could be the basis for an enormous increase in loans that could fuel inflation. How to reduce these reserves would become a pressing issue for U.S. regulators. One proposal was for the Federal Reserve to issue a new form of interest-bearing deposit certificates that it would sell to the commercial banks. China had its own dilemma. It had also adopted huge fiscal stimulus packages, which had led to an increase in government deficits, but its accumulated government reserves protected China from the challenges faced by other countries. However, the government of China compelled its banks to increase their loans, causing them to build up what might be huge non-performing loan portfolios. Furthermore, bubbles and volatility had begun to appear in real estate and stock market values. SHOULD FINANCIAL INSTITUTIONS BE PREVENTED FROM BECOMING TOO BIG TO FAIL? The question of whether an institution was too big to fail became a major element in regulatory reform. Government decisions to compel certain institutions to divest a specified portion of their business were debated. Some argued that such actions had to be taken on a case-by-case basis. Perhaps rules could not be created to cover all financial activities. The key to this discussion was the impact of a certain firm on other firms, and thus on the system as a whole if it failed. Hence, this question called for ongoing regulation focused on \"systemic risk.\" Unfortunately, individual countries could not solve this problem on their own. If such a firm could locate in a country with lax rules, then that firm could severely damage the global system. Global regulation was needed, but many feared that global action would not likely develop in the near term. In the U.S., the Glass Steagall Act of 1933 had required a separation of ownership among the alternative types of financial activities. Large U.S. banks had lobbied to have this Act repeated in order to become financial supermarkets offering all types of financial services. Some analysts blamed the repeal of Glass Steagall in 1999 as a cause of banks becoming too big for governments to allow them to fail. Mervyn King, the governor of the Bank of England, was loudly urging the breakup of banks as a necessary action to prevent a recurrence of financial crises. Alistair Darling, the U.K. chancellor of the exchequer, required the Royal Bank of Scotland and Lloyds Banking Group to sell off their branches. By the fall of 2009, the Competition Commission of the European Union (EU) was taking a leading role in compelling some institutions to divest certain assets in order to limit \"systemic risk.\" Most dramatic perhaps was the decision to compel the Dutch financial company ING to sell certain divisions, including some in the United States to raise more capital. However, many were questioning the wisdom of such government intervention in free markets. This document is authorized for use only by William Schmidt in 2016. For the exclusive use of W. Schmidt, 2016. Page 6 9B10M008 Some observers now argued that large financial institutions should be required to create a \"living will\" that would specify how the assets of the institution should be sold in the event of bankruptcy and to create a plan for responding to this possibility. IS THERE A DARK SIDE TO REGULATIONS CONCERNING CAPITAL REQUIREMENTS? A common immediate reaction to the crisis was that the capital requirements of financial institutions should be increased. Each institution should have a large enough cushion to protect its assets in the case of another sudden increase in non-performing loans or another public panic with sudden withdrawals. In retrospect, however, the capital requirements may have made the crisis worse because institutions had to sell assets quickly to prevent their eroding capital from sinking below the stipulated ratios. These forced sales caused the market values of assets to plunge when all institutions tried to sell at the same time. From this perspective, increasing the reserve requirements might not be the key to solving the dilemma. During the recession, many banks found their capital slipping toward zero. By 2010, banks were busy raising capital to try to meet their capital requirements. This reality added a new time dimension to capital requirements. For example, although the Basel II Accord (the Basel Committee on Banking Supervision's recommendations on banking laws and regulations) had set a basic requirement of 8 per cent, nevertheless, some analysts were now suggesting that the target should be raised to 12 per cent in good times to allow banks to have a cushion in bad times, with an understanding that the banks would have to have several years after a recession to climb back to the target level. In this debate, the Financial Times estimated that, \"banks could be forced to return to the average tangible common equity assets ratios they had in the 1990s. On that basis, U.S. and European banks need upwards of $1,000 bn.\"4 Meanwhile, the Basel Committee on Banking Supervision proposed that any bank that failed to meet minimum required capital levels should be prohibited from paying dividends or bonuses. Many analysts felt that the traditional \"mark to market\" rules should be changed to allow further flexibility in time of crisis. Traditionally, banks were required to calculate their net worth on the basis of current valuations of assets. However, the precipitous declines in real estate ranged as high as 40 per cent and more in some U.S. states. By 2009, more than 15 per cent of U.S. homes had a negative equity, and nearly 25 per cent of home sales were the result of foreclosures. As a result, writedowns were expected to reach more than $600 billion for U.K. bank assets, more than $800 billion for the eurozone bank assets and more than $1 trillion for bank assets in the United States. Some analysts saw these writedowns as only temporary and likely to be followed by an inevitable revival in values during a recovery. Hence, these analysts argued that it was inappropriate for banks to have to reduce their balance sheets on the basis of current market values. Perhaps banks should instead be able to meet their reserve and capital requirements on the basis of an average of several years' valuations, to smooth out the volatilities in values. The issue of capital requirements was related to the securitization process. By securitizing their loans and planning to sell these new instruments to others, the banks could remove the loans from their balance sheets. This allowed the banks to then increase their loans without technically violating the rules in regard to minimum capital ratios. Some bankers even blamed the capital adequacy rules for incenting them to expand these off-balance sheet securitizations. An interesting innovation being discussed was the possibility of requiring that banks issue what were termed \"CoCo\" bonds (short for contingent convertible bonds), which would operate as bonds in normal times but would automatically convert into equity if the bank's finances deteriorated to a specified degree. 4 \"Bank Capital 1: The Lex Column,\" Financial Times, September 30, 2009, p.12. This document is authorized for use only by William Schmidt in 2016. For the exclusive use of W. Schmidt, 2016. Page 7 9B10M008 A very important question was whether higher capital requirements would cause a shift in lending and borrowing to non-banks and to countries with lax regulations. This possibility was a far greater danger long term because the non-banks had escaped the degree of regulations that covered the banks. SHOULD CONSUMER DECISIONS CONCERNING LOANS BE REGULATED? In 2008, Canada had implemented a series of rules to reduce the risk that consumers might borrow too much in the form of a mortgage. These rules related solely to mortgages that were guaranteed by government agencies. In the past, a home purchaser could borrow 100 per cent of the purchase price of a home. This loan-tovalue ratio was now reduced to 95 per cent, requiring that purchasers have a minimum 5 per cent down payment. Although the down payment could still be borrowed separately, the new rule would create a roadblock to the 100 per cent financing that had led many into trouble. Some analysts recommended that the loan-to-value ratio should be reduced to 90 per cent. A homeowner's debt-service ratio was calculated on the basis that total debt-service payments included mortgage payments, property taxes and the cost of utilities. Traditionally, this ratio had been 40 per cent, but it now was raised to 45 per cent. The maximum amortization period, the length of time to pay off the mortgage in full, which had been 40 years, was now reduced to 35 years. Some analysts recommended that the maximum amortization period should be reduced to 30 years. New minimum standards were also decreed for loan documentation, so that borrowers could more clearly understand their commitments. In the United States, President Barack Obama expressed concern about documentation provided in regard to credit cards. In particular, Obama felt that consumers were not being made aware of various provisions that could raise their interest payments in certain conditions. Perhaps a new agency should supervise consumer credit to protect the public. SHOULD BANKERS' PAY BE REGULATED? The public was outraged that bank executives and employees who had created this financial crisis and who had asked for government bailouts should already be paying themselves huge bonuses in 2009. Some countries, such as the United States, stepped in to limit the bonuses in institutions that still owed funds from government loans. A more enduring question was whether the traditional huge pay and bonus schemes were a cause of bad decisions. Did the focus on short-term pay lead the bank executives and employees to take on inappropriate risks that ultimately would even destroy their bank? President Nicolas Sarkhozy of France advocated absolute limits on compensation, higher tax rates on bonuses and penalizing traders for trades that lost money. Others suggested that bonuses should be based on several years of profits, not on the current year's profits alone. This document is authorized for use only by William Schmidt in 2016. For the exclusive use of W. Schmidt, 2016. Page 8 9B10M008 In the United Kingdom, the government suddenly imposed a new 50 per cent supertax on banks' bonus payments. Bankers \"reacted with fury...saying the move played into the hands of rival financial centres.\"5 Some pointed to the arbitrary nature of this tax since it would not apply to the non-bank financial institutions, such as insurance companies or investment trusts. Deutsche Bank immediately announced that this tax on UK bonuses would be paid out of its global bonus pool, thereby sharing the U.K. pain among all of its employees. Meanwhile, Goldman Sachs announced it would pay bonuses to its top 30 bankers exclusively in shares that would be locked up for five years. This issue emphasized the limits of power of any one country. It seemed clear that severe regulations would lead to an exodus of bank personnel to other countries. WHICH REGULATORY REFORMS SHOULD BE IMPLEMENTED? For developing countries, a central lesson concerned the restrictions on foreign ownership in the financial sector. In particular, did a nation want to have its financial system dominated by firms that rested on a corporate culture and corporate practices that violated domestic ethical objectives and could bring risks of economic collapse? India had escaped the worst of the recession perhaps due to its foreign investment restrictions in its financial sector. At the same time, high-risk financial institutions had brought enormous benefits in terms of financing innovations and entrepreneurship. Consequently, each country had to balance the risks and benefits of such institutions and practices. To a major degree, the amazing U.S. productivity growth rested on the U.S. financial system. Reforms that restricted financial institutions also incurred a risk that these benefits might be reduced. In recent years, businesses were increasingly raising capital from a wide variety of non-bank financial institutions that included investment banks, private equity funds, hedge funds, mutual funds and pension funds. Corporations were increasingly issuing their own bonds and commercial paper. Consumers were also increasingly shifting away from the commercial banks, instead relying on credit card companies, finance companies and retailers to finance their purchases. Some analysts argued that for monetary policy to be effective and to limit systemic risk, new regulations must cover all non-bank financial institutions. By 2010, a great deal had been accomplished in terms of rescue activities for specific financial institutions. However, little had been implemented in most nations in terms of reforms of the regulatory and financial systems. In particular, little had been accomplished in creating global regulations, or in regulating nonbank financial institutions. Yet these seemed to be necessary if repetitions of such a crisis were to be prevented. Because regulatory reforms in the United States would be of importance to the entire world, the world waited to see what changes would be implemented in the United States, and how the U.S. reforms might change the system to reduce the systemic risks to the United States and the rest of the world. After very extensive debate, a reform bill finally passed the House of Representatives in December 2009 and was sent to the Senate. House Speaker Nancy Pelosi declared: 5 Patrick Jenkins and Brooke Masters, \"Bankers' Fury at UK Bonuses Supertax,\" Financial Times, December 10, 09, p. 1. This document is authorized for use only by William Schmidt in 2016. For the exclusive use of W. Schmidt, 2016. Page 9 9B10M008 We are sending a clear message to Wall Street, the party is over. Never again will reckless behavior on the part of the few threaten the fiscal stability of our people. The legislation will finally protect Main Street from the worst of Wall Street6. The bill would create a new oversight council to ensure that large financial firms would not fall into similar problems in the future. The Federal Reserve would have a key role in enforcing tougher regulations on these large firms that could otherwise risk the viability of the system as a whole. Regulators would also have the power to break up firms that had become \"too large to fail.\" Shareholders would have the right to vote on corporate pay packages. A new Consumer Financial Protection Agency would ensure that consumers had knowledge about their borrowing terms. New complex financial products would need to be explained more clearly. Congress could now order the Government Accountability Office to audit the Federal Reserve's activities regarding bailouts to prevent future rescues such as those of AIG and Bear Stearns. What the Senate would do with this bill was unclear. The financial institutions of some nations had not been hurt as much as those in the United States, which could have been the result of differences in corporate cultures as much as differences in regulations and regulatory agencies. This reality also had implications for differences in necessary regulatory reform among nations. The regulators should have intervened sooner in the legal fraud and in the illegal frauds and Ponzi schemes. However, a central problem was that the regulators were good and honest people, as are the vast majority of bankers and other business people. As a result, the regulators had difficulty in detecting the bad guys. Consider that long before Bernie Madoff was apprehended, his Ponzi scheme had been brought to the attention of regulators who were unable in their investigations to detect anything wrong. Further, the regulators were modest people of modest incomes and wealth who were trying to investigate the \"masters of the universe\" who had enormous wealth and power. Are regulators able to detect inappropriate behavior? U.S. regulators had to initiate new policies but at the same time they wished not to damage the creativity and risk-taking of the financial institutions that supported innovation and entrepreneurial activities. Perhaps to prevent a recurrence, the ethics of management had to change, which might not be likely, at least in the short term. SHOULD GOVERNMENTS USE PUBLIC MONEY TO BAIL OUT FAILING INSTITUTIONS? Governments responded vigorously with their bailout packages, which meant private losses were being funded by public money. The bailout packages may have been necessary to save the financial system in many countries and thus save the economies of those countries from further downward spirals. Similar situations had occurred in many countries in the past, such as during the Asian financial crisis of 1997, the Mexican peso crisis of 1994-95 and many other situations where a financial system was in danger of collapse. The issue of giving public money to the shareholders and management of banks to cover their mistakes has been a global conundrum for decades. Generally, analysts have always felt that the nation could not do otherwise than provide bailouts. The U.S. Treasury's Troubled Asset Relief Program (TARP) provided government loans to major banks that faced liquidity problems and also involved the purchase of non6 \"Sweeping Bank Reform Bill Clears House,\" CNN.com http://money.cnn.com/2009/12/11ews/economy/financial_ regulatory_reform/index.htm, accessed December 11, 2009. This document is authorized for use only by William Schmidt in 2016. For the exclusive use of W. Schmidt, 2016. Page 10 9B10M008 performing loans. Provisions included the government acquisition of shares in banks if they were unable to repay their debts to the government. In the hope of saving jobs, governments have often given subsidies to manufacturing firms that seemed close to bankruptcy. The recent recession brought many pleas for such assistance. Most dramatic were the requests from GM and Chrysler, which resulted in the U.S. government receiving both shares and debt. How to manage the U.S. equity positions became a challenging issue, especially in the context of the government's insistence on a shift away from the gas-guzzling models of the past to a new lineup of electric cars. Whether this transformation would be successful remained unclear. Promises of subsidies to consumers of up to $10,000 per vehicle would add to government deficits. For the firms in which governments had purchased shares, the ideal exit strategy would be to sell the shares when they regained much higher values. Governments have been involved in privatization programs for decades, and this exit strategy could be seen as a form of privatization. A real fear was that government ownership and operation might retard the recovery of these firms, especially that of GM. By December 2009, some of the banks were repaying their TARP loans from the Treasury Department, but the government was expected to lose money on the TARP arrangements overall, even in the long term. GM and Chrysler had received funding from TARP, and whether they could survive was unclear; however, the Federal Reserve's loans of some $1.3 trillion seemed to be in good shape. The loans had bought some $300 billion in short-term commercial paper from the banks, but by the end of 2009, only $15 billion was on its books. AIG had borrowed nearly $90 billion, and the Federal Reserve had taken assets in lieu of payment, thereby reducing the AIG loans to only $20 billion. The Federal Reserve's largest intervention was to purchase $1.25 trillion of mortgages and mortgage securities backed by Fannie Mae and Freddie Mac, together with $175 billion of debt issued by those companies. The current chairman of the Federal Reserve, Ben Bernanke, was predicting that overall the Federal Reserve would likely make a profit on its bailouts, but this outcome would depend on a revival of housing prices so that the mortgages would become secure. GOING FORWARD Various regulatory reforms would raise the ongoing costs of the financial institutions and might limit the pace of a nation's economic growth. Of course, another factor that could limit growth was the self-inflicted damage by these institutions. And the damage to economies and their businesses could not be reversed quickly. Thus, growth might be very slow to reach former levels, and high unemployment rates would persist. Some observers argued that instead of attempting to regulate by using a patchwork of agencies, the time had come for Bretton Woods II (in 1944, after the Great Depression, worldwide delegates had drawn up a system of rules and procedures to regulate the international monetary system, known as the Bretton Woods system). As suggested by the U.K. prime minister, Gordon Brown, a new and powerful overarching body could be charged with controlling, monitoring and regulating the international capital flows. However, the disagreements over the structure, responsibilities and powers of such a global agency would mean that its creation would likely be delayed for a very long time. Realistically, one might hope for a process of creating such an institution and then gradually expanding its role. Perhaps it was necessary to see the regulatory process as experimental. Occasionally, a major new piece of legislation, such as Sarbanes-Oxley, might attempt to limit fraud by demanding more extensive This document is authorized for use only by William Schmidt in 2016. For the exclusive use of W. Schmidt, 2016. Page 11 9B10M008 transparency and accountability. But even here it would be necessary to wait and see the unintended consequences of such dramatic changes. Some emphasized that boards of directors should view the current crisis as an opportunity to revise the way they function. During tough times, directors are expected to ask difficult questions about their companies, yet they rarely ask hard questions about themselves, such as \"Are we the right people, asking the right questions, providing the right sort of leadership, challenging management in the most productive ways?\" Perhaps boards of directors should face new legal responsibilities for transparency and accountability. The U.S. Securities and Exchange Commission issued new rules requiring that companies provide much more information on the pay of their executives and board members, including a written explanation about their pay policies. Perhaps this was a time for directors to take on greatly expanded roles in policing what was happening within the firm, especially within financial institutions. The subject was extremely complex and again the answers would not come quickly or with much certainty. Business cycles would recur in free market economies. Similarly, legal frauds would likely recur as a result of both human nature and the complexity of modern financial instruments. Consequently, business operated in a far more dangerous world than had existed in the past. Nevertheless, nations had significant differences regarding to these dangers. The world financial leader, the United States, had a national culture that encouraged individual freedom, which slipped easily into individual license to maximize personal gain without consideration for the impacts on others. Some other nations, such as Canada, rested on such concepts as \"peace, order and good government.\" Thus, Canada was, unsurprisingly, not hurt as severely by the financial crisis. The subject of ethics in business had become increasingly important. Firms now had to consider the creation and inculcation of codes of ethics. New legislation such as Sarbanes-Oxley might be able to change reporting for the better and might be able to make legal frauds illegal. Governments might be able to prosecute individuals who violated the new laws. Finally, creating new regulations that were necessary to apprehend the inappropriate actions of only a few would carry costs that would become apparent only with the passage of time. President Obama repeatedly emphasized that financial institutions had to change and that new regulations were necessary to achieve these changes with a warning that \"We cannot rebuild this economy on the same pile of sand.\"7 7 \"President Shaping a New American Form of Capitalism,\" International Herald Tribune, April 20, 2009, p. 1. This document is authorized for use only by William Schmidt in 2016