HR: What policy steps could the U.S. Department of the Treasury have taken to help the economy?
Neil Barofsky: There are all sorts of things that Treasury could have done. For example, they could have reduced the dividend rate—the amount of money that the banks had to pay in exchange for being bailed out—for lending over a baseline, which would have decreased the bank’s obligations. Or, they could have insisted on greater transparency so that banks had to disclose what they were doing with the funds. Treasury chose not to do any of these things.
HR: Weren’t there other housing programs like the Home Affordable Modification Program (HAMP)?
Neil Barofsky: Yes, but there were choices made to help the balance sheets of struggling banks rather than homeowners. The HAMP program was a massive failure but it wasn’t preordained. It was the result of choices made by Treasury officials.
HR: What could have been done differently in the HAMP?
Neil Barofsky: HAMP was deeply flawed with conflicts of interest baked into the program. The management of the program was outsourced to the mortgage servicers, which were thoroughly unprepared and ill equipped. The program encouraged servicers to extend out trial modifications. It was supposed to be a three month period but it often turned into more than a year. The servicers, because they could accumulate late fees for each month during the trial period, were incentivized to string the trial periods out then pull the rug out from under the homeowner, putting them into foreclosure, without granting a permanent mortgage modification. The servicers could make more money doing that then by doing mortgage modifications. If they had done permanent mortgage modifications, the banks couldn’t have kept the late fees.
HR: Are you saying that the program encouraged banks to extract as much cash as possible from homeowners before foreclosing on them anyway?
Neil Barofsky: Yes. The mortgage servicers exploited the conflicts of interest that were in the program, and blatantly broke the rules, and Treasury did nothing.
HR: When you were serving as Inspector General for TARP, you issued a report indicating that government commitments totaled $23.7 trillion. What was that about?
Neil Barofsky: $23.7 trillion was simply the sum of the maximum commitments for all the financial programs related to the financial crisis. The number was misconstrued as a liability but the government never stood to lose that much. For example, the government guarantee of money market funds was a multi-trillion dollar commitment. Of course, not all of that money could have been lost because it would have required every fund to go to zero. The government guaranteed commercial paper but, again, for that commitment to have been wiped out, every company would have had to have defaulted. But the numbers were very important in terms of transparency. All of the data were provided by the agencies responsible for the various programs, so the $23.7 trillion number was simple arithmetic. It was important to understand the scope of the extraordinary actions that were being taken.
HR: What are the potential future losses that the U.S. government—that taxpayers—might have to absorb?
Neil Barofsky: The real issue is the potential for another financial crisis because we haven’t fixed the core problems of our financial system. We still have banks that are “too big to fail.” Standard & Poor’s estimated last year that the up-front cost of another crisis, including bailing out the biggest banks yet again, would be roughly 1/3 of the U.S. gross domestic product (GDP) or about $5 trillion. The resulting problems will be even bigger.
HR: What were the problems resulting from the 2008 financial crisis?
Neil Barofsky: When you look at the fiscal impact of the 2008 crisis, you have to look at it not only in terms of lost tax revenues and increased government debt, but also in terms of the loss of household wealth. People who became unemployed suffered tremendous losses and the government’s social benefit costs expanded accordingly. One of the reasons we had the debt ceiling debate last year, when the U.S. credit rating was downgraded, and why we are facing a fiscal cliff ahead is the legacy of the 2008 crisis. We have a lot less dry powder to deal with a new crisis and we almost certainly will have one.
HR: Why do you expect another financial crisis?
Neil Barofsky: It just comes down to incentives. A normally functioning free market disciplines businesses. The presumption of bailout for “too big to fail” institutions changes the incentives of a normally functioning free market. In a free market, if an institution loads up on risky assets with too little capital standing behind them, it will be punished by the market. Institutions will refuse to lend them money without extracting a significant penalty. Counterparties will be wary of doing business with companies that have too much risk and too little capital. Allowing “too big to fail” institutions to exist removes that discipline. The presumption is that the government will stand in and make the obligations whole even if the bank blows up. That basic perversion of the free market incentivizes additional risk.
HR: Are “too big to fail” banks taking more risks today than they did before?
Neil Barofsky: Bailouts give bank executives an incentive to max out short term profits and get huge bonuses, because if the bank blows up, taxpayers will pick up the tab. The presumption of bailout increases systemic risk by taking away the incentives of creditors and counterparties to do their jobs by imposing market discipline and by incentivizing banks to act in ways that make a bailout more likely to occur.
HR: Is it just a matter of the size of banking institutions?
Neil Barofsky: The big banks are 20-25% bigger now than they were before the crisis. The “too big to fail” banks are also too big to manage effectively. They’ve become Frankenstein monsters. Even the most gifted executives can’t manage all of the risks, which increases the likelihood of a future bailout.
HR: Since bank executives are accountable to their shareholders, won’t they regulate themselves?
Neil Barofsky: The big banks are not just “too big to fail,” they’re ‘too big to jail.’ We’ve seen zero criminal cases arising out of the financial crisis. The reality is that these large institutions can’t be threatened with indictment because if they were taken down by criminal charges, they would bring the entire financial system down with them. There is a similar danger with respect to their top executives, so they won’t be indited in a federal criminal case almost no matter what they do. The presumption of bailout thus removes for the executives the disincentive in pushing the ethical envelope. If people know they won’t be held accountable, that too will encourage more risk taking in the drive towards profits.
HR: So, it’s just a matter of time before there’s another crisis?
Neil Barofsky: Yes. The same incentives that led to the 2008 crisis are still in place today and in many ways the situation is worse. We have a financial system that concentrates risk in just a handful of large institutions, incentivizes them to take risks, guarantees that they will never be allowed to fail and ensures that the executives will never be held accountable for their actions. We shouldn’t be surprised when there’s another massive financial crisis and another massive bailout. It would be naïve to expect a different result.