22 November 2023
Timothy F. Geithner spent most of his career dealing with financial crises. He served as President of the Federal Reserve Bank of New York, then as President Barack Obama’s secretary of the Treasury. He helped the United States deal with the Global Financial Crisis, which he ultimately covered in great detail in his book specifically on Financial Crisis’, which he titled Stress Test.
According to David Bassanese, chief economist at BetaShares Exchange Traded Funds, the risk for a technical recession in Australia is now at a 50/50 proposition. Whether or not that’s true, the potential of a recession is on many people’s mind with coronavirus continuing to dominate the headlines and many of the world stock markets taking significant declines.
Geithner’s extensive experience in the nature of a financial crisis provides an interesting understanding of the psychology of a market downturn that we can maybe learn from and consider as recession fears arise.
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What is a financial crisis?
According to Geithner, a financial crisis is a crisis in belief.
Financial systems are built on belief and only work when people have confidence in the system. People trust the bank with their money. The bank will lend it out and return an interest, in return trusting people to not take their money out all at once.
In a crisis, people lose confidence that their money is safe in the system. They rush to take their money out at once, whether it be from stocks, the bank or funds. It means that the money left is even more unsafe and this in turn makes everyone less confident.
Humans are irrational. We are prone to both panic and confidence, either believing in the system or losing trust in it.
Financial recessions are often preceded by an economic upswing. This peak phase is considered part of the economic cycle but the subsequent downswing can be unpredictable and in some cases severe. One can track the current reaction to the coronavirus panic and the equally volatile reaction in the Share Market to these thoughts as well. As long as confidence in the system remains low, confusion and fear will continue to dominate.
Why confidence is important – Geithner’s thoughts on the GFC
Geithner’s most important experience was arguably with the Global Financial Crisis in 2008, when he was the US Treasury Secretary for Barack Obama’s cabinet.
The GFC was caused by a series of events that created a domino effect, the most famous of which was the collapse of the Lehman Brothers Investment Bank. Other big institutions such as the insurance giant American International Group (AIG) and savings bank holding company Washington Mutual (WaMu) were also significant dominos in the crisis.
The fall of these institutions created great fear in the market. The banks became defensive, and held onto their cash. There was almost no credit available for ordinary borrowers. Businesses were laying off more workers and investing less, which in turn meant people were even less inclined to spend. This slowed down the economy.
The Troubled Asset Relief Program (TARP) was Geithner’s 700 billion dollar intervention. By saving the giants, Geithner and his team essentially attempted to pile dollar bills in the banks’ windows to show the people the system was still working, a method to inject confidence back into the system.
“We had to do whatever we could to help people feel their money was safe in the system,” Geithner says.
To show how important confidence is, Geithner highlighted an example of a domino tackled wrong by the US government. Their actions decreased confidence and led to a major bank run.
The domino was WaMu, the nation’s largest savings and loan association. It was a big player in the mortgage market, but their stock price had dropped 90% during the crisis. After Lehman fell, depositors pulled $17 billion out of WaMu in ten days, and on September 25, 2008, it was shut down by the U.S. Federal Deposit Insurance Corporation (FDIC).
Sheila Bair, President Bush’s FDIC Chair, agreed to sell WaMu to JPMorgan Chase who would take over the bank’s deposits. But JPMorgan wasn’t required to stand behind WaMu’s other obligations, leaving the bank’s senior debt owners exposed to severe losses. This was a good deal for JPMorgan and for the FDIC. It adhered to the least cost mandate, but according to Geithner it was detrimental to the country.
“Bank creditors couldn’t be sure which institutions might end up like Lehman or WaMu so they ran from everyone […] Even those who didn’t think the situation necessarily called for running often felt like they had to run when they saw others running,” Geithner says.
Sheila Bair wanted to protect the FDIC by exposing it to less risk and wanted to make an example of punishing WaMu bond holders. However, Geithner believed that more haircuts would lead to more bank failures, which would hurt the FDIC in the long run as well.
“Imposing losses when we had the power to prevent them would send a clear signal to other creditors of US banks that they too were exposed to losses and should put their money somewhere safer if they didn’t want haircuts.”
JPMorgan’s acquisition of WaMu created more fear, and the perceived risk of lending to US banks increased drastically overnight.
“The markets ran first and fastest from Wachovia, a much bigger bank that was also in trouble and now looked like it could be the next candidate for similar haircuts,” Geithner says. Wachovia was the next domino in line to fall, only it didn’t. It was acquired by Citigroup who, unlike JPMorgan was obligated to stand behind the debt.
What to take away from all this
George Santayana famously once remarked ‘those who do not remember history are doomed to repeat it.’
We find ourselves in a new decade, at the beginning of our own financial stress test. Markets rebounded slightly on Tuesday’s promise of a Central Bank stimulus, and the Coalition is readying a rollout of its own on Thursday the 12th, which the RBA says ‘will provide welcome support’.
Geithner’s experience is an interesting look into how financial crises work, and what drives them. The parallels with panic and fear of an economic slowdown due to the coronavirus is impossible to ignore. With factories closed or closing around the world, cross-border travel shrinking, cargo ships idled and fear of the virus continuing to rise and having an impact on consumer behaviours, demand for oil may still fall further. But, like the last Stress Test we suffered, the crisis ended, lack of confidence and panic resided, smart and questionable economic decisions were made at a governmental level and investors sought to protect themselves from market volatility.
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