America's future can be seen clearly in today's European crisis over sovereign debt. What is not clear is the path our country will take to resolve our own economic crisis.
First, some facts. American companies are reportedly sitting on more than $2 trillion of cash that they could invest, but haven't yet. Businesses are not investing because they are awaiting consumers to start buying again. Consumers aren't buying because their homes today are worth some $7 trillion less than their 2006 value -- and home prices keep dropping. The Wall Street Journal's David Wessell reports that according to the International Monetary Fund, "holders of U.S. mortgage and other debt lost $2.7 trillion in the U.S. phase of the global crisis." These facts explain why the U.S. economy is effectively blocked -- with stagnant economic growth and 9 percent unemployment. "Neither a borrower nor a lender be" seems to sum up where we are.
Contrast this situation with the Eurozone. In the case of Greece, the government for years has borrowed to fund obligations it could not afford. One example: the maximum annual U. S. Social Security payout is $28,000. In Greece that figure is $48,000. So Greek governments paid overly generous public benefits -- salaries, pensions -- and financed them by borrowing heavily from several European banks. As Greece moves towards addressing the problems (including a prolonged period of "austerity" during which these unsustainable benefits will be reduced), there has finally been a recognition that the banks who loaned billions of Euros to the Greek government made a bad bet.
And just like former U.S. Senator and New Jersey Governor Jon Corzine, whose MF Global Fund made bad bets on the future of European sovereign debt instruments and went bankrupt, the European bank lenders now realize that they will have to absorb losses approaching 50 percent of their loan value. As yet unresolved is whether those banks' governments will come to their rescue if they end up on the verge of failing.
When people, financial institutions, and governments make bad bets, someone has to lose money. In the case of Greece, we know precisely where the borrowed money went: into unsustainable benefits. In the case of the United States, we are still sorting out the winners and losers from the housing and subprime mortgage bubble, but what is abundantly clear (albeit no one wants to state it) is that the $2.7 trillion loss is a real figure that has to come out of somebody's pockets.
To date, our political leaders and even the Federal Reserve have been ducking this reality, in part hoping that home prices will rebound and help reduce the losses associated with the subprime and other delinquent mortgages that are still held by financial institutions. The bailout of several banks and automobile companies may have prevented a financial system meltdown three years ago, but our ongoing refusal to recognize the losses still on the books of our financial institutions is a major reason why the U.S. economy's recovery has been so slow and painful.
American banks are no different than those European banks now wrestling with European sovereign debt in countries like Greece, Italy, Spain, and Portugal. As Michael Lewis writes in his new book, Boomerang, the global crisis may have begun with the spectacular failure of several Icelandic banks, but at least Iceland's government moved promptly and forcefully to close the worst offenders. As noted with Greece, the bond and equity holders of several major European banks are going to face losses of 50 percent on their holdings of Greek sovereign debt -- a just reward for a bad bet.
What haircuts, if any, will American financial institutions face? It's not clear. When Japan faced a collapsing commercial real estate market as the result of a bubble, we urged Japanese banks to move quickly to liquidate the nonperforming assets from their banks' balance sheets. They did not for many years and thereby prolonged a deep economic slump.
We are now ignoring our own advice to the Japanese and reaping the same economic stagnation. Those institutions that made bad bets on the American housing market need to step forward and take the haircuts now. There may be some failures, as in Iceland, or major losses as will soon occur in Europe. Continued delay while hoping for another government bailout that "socializes the losses" by transferring them to taxpayers is the wrong approach. Some financial institutions may disappear, but the system will not collapse.
Some 20 years ago -- and on a far smaller scale -- I faced a similar situation when I served as a Deputy Under Secretary in the U.S. Department of Education. The lessons I learned then offer some guidance for today.
At the time, the federal guaranteed student loan program operated on the basis of an explicit federal guarantee of loans made to students by thousands of private sector banks. In many cases, the banks that originated these loans to students sold them later to a secondary market known as SallieMae, the Student Loan Marketing Association -- the functional equivalent of FannieMae and FreddieMac for housing. The rationale was the same: by creating a strong secondary market for student loans, banks could free up even more capital to loan to our students for their postsecondary education. Banks, including those institutions that bought the original loans, had an incentive to make such loans: they received subsidies in the form of interest payments and special allowances while the borrower was still in school, and, of course, the federal guarantee to pay off the loan in the event the borrower defaulted.
The national student loan policy was to make more loans to enable more Americans to have access to postsecondary education -- just like the national housing policy was to increase the number of U.S. homeowners. In the case of student loans, however, there was a requirement that had to be met before a bank could collect on that federal guarantee. The U.S. Department of Education prescribed a series of "due diligence" rules -- basically contacting the debtor by mail and/or telephone a certain number of times during a prescribed period -- that had to be met before a default would be paid by Uncle Sam. If the "due diligence" rules were not followed, then the federal government would not pay the insurance guarantee on a defaulted student loan.
When Lauro Cavazos served as U.S. Secretary of Education, a loan servicer in California failed to meet the "due diligence" requirements on a portfolio of student loans estimated between $500 million and $1 billion. The loan servicer had been hired to follow up with the delinquent borrowers to try to collect on the defaulted loans and had to meet the due diligence requirements. Unfortunately, the loan servicer took on more business volume than it could handle, and it failed to meet the timetable associated with the due diligence rules. As a result, somewhere between $250 million and $500 million of defaulted loans in the portfolio did not satisfy the requirements for collecting on the federal guarantee.
The question then -- as today -- was who would bear the loss?
As Deputy Under Secretary, this matter landed first in my lap, and I studied the matter very carefully. I had countless meetings with bankers from around the world who would have been left holding the bag -- taking the losses on the now securitized loans -- if the federal guarantee was withheld. It would have been their responsibility to collect on the defaulted loans themselves.
On one occasion, Secretary Cavazos and I met with the CEO of a major American bank which held a significant portion of this unserviced loan portfolio. His message was clear: if the federal government didn't bail out the banks, waive the "due diligence" requirements, and pay the guarantee on the defaulted loans, the entire student loan program would collapse.
It was my first encounter with the "too big to fail" argument.
It was clear that the failure was a private-sector mistake; in no way was the U.S. government responsible for the problem. I was planning to recommend to the Secretary that we not waive the due diligence rules and thereby not rescue the holders of the bad paper. As my intentions became clear after consulting other Education Department officials, one senior career staffer from the Office of Postsecondary Education approached me after a meeting. With tears in his eyes he begged me to reconsider and bailout the loan holders. He said, politely, that I did not realize what I was doing and that my decision would bring down the entire federal student loan program. I thanked him for his candor and told him how much I appreciated his opinion -- but that I disagreed.
One of the reasons this particular student loan portfolio had such a high default rate was due to many of the loans having gone to students who attended poor quality for-profit trade schools. There are many examples of outstanding proprietary schools in postsecondary education, but at this particular time, student loan defaults were rising, and there were countless examples of high student loan default ratios associated with schools that took their students' Pell Grants and guaranteed student loans while failing to provide them with the skills needed to get a job -- and repay the loans. (Does this situation seem a little bit similar to subprime mortgages?)
In addition to enforcing the due diligence rules, the position the Department of Education ultimately took was also intended to drive out of the student loan program as many of the poor-quality institutions (for-profit and not-for-profit) as possible.
When the decision was announced that the losses from this student loan portfolio had to be borne by the private sector, and not the U.S. taxpayer, I remember receiving a call from a reporter at Barron's. Before launching into questions about the Department's decision, she began by saying "congratulations" and added that she could not recall another instance where a cabinet department had made such a difficult decision and stuck to its principles. She then began the interview.
So what happened to the federal guaranteed student loan program? It did not collapse. On the contrary, a year later there were more outstanding student loans going to more students than ever before. However, there were fewer student loans going to students attending poor-quality institutions -- precisely the outcome we expected.
The lessons from this much smaller experience are relevant to today's much broader and deeper crisis.
First, losses have to be borne. The issue is whether the private-sector actors take the hit or whether the losses are shifted to the American taxpayer.
Second, whatever decisions are ultimately made will create a set of incentives that will influence behavior going forward.
Third, claims that an entity is "too big to fail" need to be analyzed very carefully and, in most instances, greeted with initial skepticism. Most entities facing major losses associated with bad bets will find a way to invoke the "too big to fail" argument. If somebody else can absorb the loss, then, hey, what the heck, it's worth asking.
Fourth, our leaders -- elected and appointed -- need to represent and protect the American taxpayer's interests.
Fifth, there should be complete disclosure of the losses involved and the costs to-date, including full transparency by the Federal Reserve.
Americans are generous, forgiving people. But we do not like being taken for fools.
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Charles Kolb served in the first Bush White House from 1990-1992 and as General Counsel of United Way of America from 1992-1997. He is now President of the Committee for Economic Development in Washington, D.C. The views in this article are solely the author's.