The turbulent financial market events of recent days demonstrably signal the end of Wall Street as we know it. More uncertainty lies ahead, on Wall Street but also for the national economy. How is this affecting New York and what will it take to get the economy moving again?
After The Bubble Burst
Six months ago, a "disastrous foray into financial wizardry" by banks and lenders led us to the sight of the Federal Reserve giving J.P. Morgan Chase $28 billion to take over Bear Stearns. It was thought that this unprecedented action might calm the panic triggered by the sub-prime lending fiasco. The bursting of the housing bubble destroyed billions of dollars of equity people held in their homes and started to jeopardize millions of mortgages across the country, prime as well as sub-prime. This mortgage meltdown led the U.S. Treasury Department earlier this month to take over the two quasi-public mortgage giants- Fannie Mae and Freddie Mac, which together hold nearly half of the $12 trillion in outstanding mortgage debt in the U.S.
Despite several unprecedented actions by the Federal Reserve and the Treasury Department over the past six months, financial market conditions continued to worsen. Reportedly, hedge fund speculators, seeking to profit from the woes of others, used short-selling to drive down the share price of Lehman Brothers. Some market insiders contend this contributed to the demise of the fourth largest U.S. investment bank.
With no clear roadmap on how to avert a collapse, the federal government's response swung wildly over the week in diametrically opposed directions. At first, the Fed and the Treasury sought to draw the line on further taxpayer bailouts, denying federal aid to Lehman Brothers. Lehman had no choice but to go into bankruptcy on Sept. 15. Pictures of dour-faced employees carrying their personal belongings out of Lehman's offices splashed across newspapers and television screens. To avoid Lehman's fate, Merrill Lynch hurriedly agreed to be taken over by Bank of America.
Initially, the Fed had denied aid to insurance giant AIG. The day after it stood by while Lehman went belly-up, though, the Fed reversed course. Officials decided there was an imminent danger of far-flung cascading financial defaults and agreed to an $85 billion taxpayer bailout of AIG in exchange for an 80 percent ownership stake in the company.
Initially euphoric after the AIG bailout announcement, financial markets went into full-blown panic on Sept. 17, and investors and speculators mercilessly drove down the share prices of the remaining financial industry leaders. Panic even spread to the $3.4 trillion money market fund industry where millions of average investors place their savings. The credit markets "seized up," meaning that institutions became fearful of lending to each other because of the tremendous uncertainty about whether the borrower would be able to repay. Stock markets dropped sharply around the world.
The Biggest Bailout
Writing in the Wall Street Journal on Wednesday, former Fed Chairman Paul Volcker proposed the equivalent of a new Resolution Trust Corp. After the savings and loan crisis of the 1980s, the RTC assumed the assets (mainly commercial properties) of failed institutions and sold them in an orderly fashion. Ultimately, billions of dollars were returned to the public treasury. The net taxpayer cost of that massive bailout was about $100 billion.
Volcker's support for a new Resolution Trust Corp. helped legitimize an idea that had been gaining currency in recent weeks. By the end of last week -- a week that started off with officials saying "no more bailouts" -- Treasury Secretary Henry Paulson, after consulting with congressional leaders, announced that the federal government would provide what amounts to "the mother of all bailouts." Paulson's proposal, the details of which were still being negotiated with Congress as of this writing, amounted to an RTC on steroids but called for the Treasury Department itself -- rather than the new trust corporation -- to handle the purchase of shaky loans and other hard-to-sell securities.
What's the price tag for this umbrella Wall Street bailout? An eye-popping $700 billion, roughly the amount of U.S. government outlays to date in the phenomenally costly Iraq War. This would push the total tab for bailing out Wall Street to well over $1 trillion.
The White House also announced two other historic actions. The government would insure deposits in money market funds, the modern-day equivalent of the Great Depression move to have government insure bank deposits. And the Securities and Exchange Commission banned the short-selling of all financial sector stocks. (In a short sale, a stock is borrowed by an investor expecting the stock's value to drop, and then sold. After the price falls, the borrower buys the stock to re-pay the original owner, pocketing the difference.) Some market participants sharply criticized the short-selling ban, while many of those critics and others pointed the finger at the SEC for failing to properly oversee the financial markets in the first place.
The government's decision to seemingly empty the taxpayer's purse to provide a wall-to-wall Wall Street rescue produced euphoria on Wall Street at the end of last week. On Thursday and Friday, the Dow Jones industrials, which had plummeted earlier in the week, soared by 780 points. Despite that giddiness, it remains to be seen how exactly the Paulson bailout proposal will handle several highly contentious details and whether these actions will suffice to stabilize the financial markets.
The Ripple Effects Locally
In the early summer, experts projected 30,000 jobs would be lost on Wall Street, perhaps forever, while New York City would lose 80,000 to 90,000 jobs overall. Those estimated now are being revised upward. The state labor department now expects 40,000 lost Wall Street jobs and a total job loss for the city in the neighborhood of 120,000. As severe as those job losses would be, in the 2001 to 2003 recession/downturn, New York City lost about 40,000 Wall Street jobs and nearly 240,000 overall. In the downturn of the late 1980s and early 1990s following the bursting of the commercial real estate bubble and the savings and loan crisis, the city lost even more: 360,000 jobs or 10 percent of the total in the city.
The economic decline is well underway in New York City, extending beyond the financial district. Jobs are declining in businesses supplying Wall Street, such as law firms, temp agencies, caterers and car services, as well as in retail. Over the summer, the number of New York City workers filing for unemployment insurance jumped by 25 percent over the prior year. Workers' paychecks are taking a beating as well, as the price of gasoline, food and housing have soared. The Fiscal Policy Institute estimates that the inflation-adjusted median hourly wage in the city fell by 4 percent in the 12 months between June 2007 and June 2008.
The adverse effects to the city economy of the Lehman bankruptcy were moderated when London-based Barclay's Bank agreed to buy Lehman's investment banking and trading units. Barclay's also agreed to purchase Lehman's billion dollar headquarters building in Midtown. Still, shrinking financial firms will increase office vacancy rates in both Downtown and Midtown, and bring down asking rents. In this environment, it is unlikely that ground will be broken on any new office buildings. The loss of so many high-paying jobs will push Manhattan condo prices down, particularly now that the recession has spread to Europe. All of this will shrink tax revenues, leaving city and state budget officials to face the unwelcome pain of budget cuts and tax increases.
Crafting a Better Bailout
While the effects of the financial market meltdown are particularly acute in New York, Wall Street remains the core of the national financial system. The proposed Treasury bailout might help stabilize the financial markets, but that is far from certain.
A great deal is at stake in the negotiations that will occur before Congress passes the necessary authorizing legislation, promised by the time it adjourns on Sept. 26. It is clear, however, that other actions will be needed before a sustainable national recovery can get underway. New York cannot -- and should not -- face this crisis alone. The city, the state and the country all need a forceful and on-target response from the federal government.
The key issue right now is stabilizing the housing market. Most financial institutions should be able to weather this storm if the Treasury removes from their balance sheets home mortgages whose values had been falling and if the housing market stabilizes as a result. To accomplish that, the Treasury should only take over home mortgage debt.
The legislation authorizing the proposed Treasury bailout should make sure that institutions are not let off the hook for making excessively risky investments in derivatives and other highly speculative debt instruments. Those institutions that had highly leveraged themselves with very speculative bets should have to fend for themselves. The legislation should require complete disclosure of holdings as a condition of assistance.
The legislation should also require that the Treasury go to great lengths to keep people in their homes by re-negotiating mortgages on favorable terms for moderate- and middle-income home owners who have a realistic chance of paying off a new mortgage. In those cases where home owners do not have sufficient income to carry even a modified mortgage, the Treasury should allow them to rent their home in order to minimize displacement.
Washington needs to establish a new regulatory regime that covers all financial institutions (including hedge funds), controls risk and introduces a tax on financial transactions to help repay U.S. taxpayers for coming to the industry's rescue.
Above all, regulations should prevent the development and trading of high-risk, speculative instruments that do not serve a clear economic purpose. Capital requirements should be raised to prevent dangerous degrees of leveraging. Transactions have to be much more transparent and fully disclosed. As many experts such as Dean Baker have suggested, there also should be limits on compensation on Wall Street because history has demonstrated that unlimited compensation promotes excessive risk-taking.
It is critically important that the bailout authorizing legislation be linked to a second round of stimulus measures sufficient to jump-start an economic rebound. The $150 billion federal stimulus package enacted by President Bush and Congress in February provided a brief up-tick in consumer spending in May and June, but the rising price of gas and food swallowed up a good chunk of those tax rebates. A more robust and better-targeted stimulus package should be a condition for passage of the bailout legislation, and it should include:
- Sizable fiscal relief to the states so they will not have to cut spending, further eroding jobs and services and hurting the economy;
- Extended unemployment benefits and increased food stamp and home heating assistance, all measures that offer the most economic stimulus per dollar;
- Funding improvements in state and local infrastructure. This will not only address long-standing needs and support economic growth, but will ensure that there will be a stimulant a year or two down the road when it will still be needed.
Wall Street is going through a dramatic downsizing. Some of that is warranted because, motivated by unbridled greed and encouraged by reckless de-regulation, Wall Street assumed a disproportionate role for itself in the economy. According to The Economist magazine, the finance sector's share of U.S. corporate profits rose from 10 percent 25 years ago to 40 percent last year. This dramatic rise depended, in part, on a panoply of unsustainable practices that do not serve a productive purpose.
Wanted: A Real Recovery
The slumping housing market and the debt many households took on in recent years present the major impediments to an economic recovery. Families everywhere had turned to home equity and credit card debt to make up for stagnant wages. As the Economic Policy Institute has pointed out, the 2001 to 2007 economic cycle was the first time since at least the Great Depression when wages for most workers did not surpass their previous peak -- which, in this case, was reached in 2000.
A set of medium- and long-term policies is necessary to help rebuild the middle class and move the U.S. economy toward shared prosperity. These include:
- Universal health insurance that will provide lower-cost, quality options for millions of the uninsured and aid U.S. businesses of all sizes;
- Increasing the minimum wage to its 1969 peak value and then indexing it to inflation to help millions of workers struggling to escape poverty;
- Enacting the Employee Free Choice Act to circumvent illegal employer actions that thwart the efforts of workers to unionize;
- Instituting a progressive tax increase that would help pay for important investments, including in higher education and skills training for those young people who do not attend college.
Without these and similar measures that foster a middle class, the U.S. economy likely will continue to bump along from crisis to crisis, whether or not the financial markets recover.
Getting Back to Work
Wall Street Journal writer Dennis K. Berman recently observed:
"Perhaps some of the country's brightest students might now recognize that the new path to wealth isn't a few years of hit-and-run work on the Street or at a hedge fund. This is a positive thing. It encourages the country to get back to creating, building and doing, rather than shuffling paper and trading it. ... The market has indeed spoken. Its message is clear: It is time to get back to work. Real work."
Amen.
While many New Yorkers justifiably took pride in our city's resilience and rebound after 9/11, we have to acknowledge that our rebound road a wave of Wall Street speculation and excess. Now, it's time to get back to work. Wall Street self-destructed. More than ever, all of us -- not only in New York -- need broadly shared prosperity, and we need a big boost from Uncle Sam to help get us there.
Maybe, a symbolic first step is to re-name Wall Street. "Broadly Shared Prosperity Place" might serve a useful reminder to financiers about the job they have to do.
James Parrott is deputy director and chief economist of the Fiscal Policy Institute (www.fiscalpolicy.org). He has been studying and writing about the New York economy since he landed in New York City a quarter century ago.Â
