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Peter Atwater: The Critical Takeaway from Lehman and AIG


Policymakers' actions were neither arbitrary nor capricious. They mirrored precisely what social mood was demanding in October 2008.

With Hank Greenberg's AIG (AIG) trial about to get underway, Neil Irwin wondered the following aloud in Sunday's New York Time:

Were the policy makers who led the fight against the crisis - principally the Federal Reserve chairman Ben Bernanke, Treasury Secretary Hank Paulson and the New York Fed chief, Timothy Geithner - heroes who rescued the global economy through creativity and bravado? Were they stooges of Wall Street who funneled hundreds of billions of taxpayer dollars to the financial industry? Did they wield power with a vindictive, arbitrary approach that left them picking winners and losers? Should the policy makers have been more stingy? More generous? More consistent?"

He went on to day:

For the public, the decisions on whom to bail out, nationalize or allow to fail surely seemed random. Bear Stearns? Government-assisted bailout. Fannie Mae and Freddie Mac? Government takeover. Lehman Brothers? Bankruptcy. A.I.G.? Bailout.

To the policy makers involved, the decisions seemed methodical and grounded in the unique circumstances of each firm involved and their legal authorities. Is it a bank? Is it solvent? Is it systemically important?

But the policy makers were reluctant to lay out in advance some framework of what institutions would be rescued and which weren't, viewing strategic ambiguity as their friend. They didn't want to pre-commit. That added to the uncertainty of a difficult time, and with hindsight some clearer sense of the rules of the game when the financial system is under stress might make the consequences less severe.

Having watched the financial crisis unfold closely, I can relate to Mr. Irwin's concerns about the seemingly arbitrary approach taken by policy makers.

I spent many Sunday evenings pouring over hot-off-the-press documents and public statements, most of which were filled with grammatical and spelling errors which would have enraged a middle school English teacher. If decisions were not being made at the last minute and on the fly, our banking regulators did a masterful job of hiding it.

Having spent the past five years studying socionomics and confidence-driven decision making, and the seemingly seat-of-the-pants actions taken by public policy makers clearly aligns with the dramatic decline in confidence that started in the summer of 2007.

To see why this was the case, let me first offer three pieces of background information.

First, there is a highly reflexive relationship between confidence and the financial services and housing industries. As these two charts show, how we feel about our own economic confidence is quickly reflected in the stock prices of banks and home builders.

Bank Stocks Broadly Follow Social Mood

Housing and Confidence Are Correlated

While economists will forever debate which was the chicken and which was the egg, what is clear is that the collapse in the financial services and housing industries from 2007 to early 2009 mirrored a collapse in American's economic confidence.

Second, as I have written, public policy makers react to and follow social mood.

The confidence expressed by the markets and voters impacts policy makers' actions. The better we feel, the better they (policy makers) feel about the economy and the safety and soundness of the financial system. Not surprisingly, banking regulators acted aggressively to restrict the actions of financial institutions at the very bottom of the Great Depression when confidence was extremely low, and then they aggressively deregulated those same banks at the peak of confidence in the late 1990's. 

The regulators were following mood.

But there is an important corollary to this.

How we feel about the regulators and public policymakers also ties to our own level of confidence. This creates a critical, but not well-understood, relationship between our feelings about ourselves, the banks, and the regulators. 

The better we feel about ourselves, the better we feel about the system.  Conversely, when we feel poorly, we take a negative view of the banks and regulators.

That then-Fed Chairman Ben Bernanke first suggested that problems in the subprime mortgage space were "contained" at the outset of the crisis was not a surprise. He, like most policy makers, was reflecting the high social mood/public confidence at the time. That his comment was not aggressively challenged also speaks to high confidence. Held in high esteem, like his predecessor Alan Greenspan, the public had no reason to doubt Chairman Bernanke's assessment. 

We believed in him like we believed in ourselves and the banks.

Finally, our level of confidence shapes the nature of our actions. When our confidence is high, our decisions reflect collective interest, global physical proximity, ethnic diversity, long-term time frames, and a desire for innovation and complexity -- what I call "us, everywhere, forever, complicated" choices.

Conversely, when our confidence falls, self-interest, close physical and ethnic proximity, short-term time frames, and a desire for tradition and simplicity -- what I call "me, here, now, simple" choices -- dominate our preferences, decisions and actions.

Looking at the progression of public policy makers' decisions from 2007 to early 2009, you can see a very clear migration from "us, everywhere, forever, complicated" to "me, here, now, simple" preferences, decisions and actions. They were following our declining mood.

For example, as the crisis unfolded, the terms of every public policy intervention became more severe to more participants in the capital structure. 

In Bear Stearns, the government helped facilitate an orderly transfer of the business to JPMorgan (JPM). All creditors and preferred shareholders were spared. Even common shareholders received some level of value.

The common shareholders in future failures were not so lucky.  When Fannie (FNMA) and Freddie (FMCC) failed, preferred shareholders took a hit. Then, when Washington Mutual failed, so did the creditors of the holding company.  And when Lehman failed, no one was spared. 

Extremely weak confidence resulted in a dismissal of all the potential lifeguards from the beach. Given all that had happened from the summer of 2007 to the fall of 2008, there was a strong, collective belief that the swimmers should have known better.

By the fall of 2008, bailouts which had been initially viewed as a positive were seen as extremely negative by voters. This was not at all a surprise given the collapse in confidence that had occurred. When our level of confidence falls, not only does our self-interest soar, but we "acquire" zero sum thinking.  We believe that our own misfortune had to have come at the expense of someone's gain.  "Main Street had been victimized by Wall Street." 

To then reward Wall Street with bailouts didn't fit with the narrative of our zero sum thinking. 

For public policy makers responsible for the systemic safety of the financial system, the public's zero sum thinking and demands for a scapegoat eliminated the available options. The government could not intervene again. If Wall Street wouldn't step up to save one of its own (Lehman Brothers), then a Wall Street firm had to fail.

And fail it did.  An act of sacrifice, which so often happens at the very bottom of a cycle in confidence, occurred.

But something else occurred with the failure of Lehman Brothers that few appreciate six years later. With Lehman's collapse came a change to the public narrative. While Main Street had been victimized by Wall Street, failure couldn't happen again. From voters to Congress to the regulators themselves, no one wanted a second Lehman Brothers. 

The decline in confidence that had started in August 2007 had turned into a panic. The uncertainty was overwhelming and something needed to be done to restore confidence.

At that point, public policy makers were desperate for certainty as dictated by social mood: Save us (and by necessary reflexive association Wall Street) from another panic, but extract every possible concession in the process.

This week, with the AIG trial under way, we are seeing the details of what this meant back in the fall of 2008 -- what being simultaneously saved and beaten looked like for financial institutions at the very bottom of the banking crisis.

While Mr. Greenberg may not like it, that was the social mood-driven public mandate given to public policy makers. Save, but punish.
Policymakers' actions were neither arbitrary nor capricious; they were reflexive. They mirrored what social mood was demanding in October 2008.

To be fair, American public policymakers were hardly unique in their responsiveness to social mood.  I watched similar behaviors evolve with the European banking/sovereign crisis as well.  As Ambrose Evans-Pritchard recently shared in the London Times, in 2010 the ECB demanded that Irish policymakers save the creditors of that country's failing banks in return for "ECB support for the Irish banking system."

When the banking system collapsed in Cyprus just three years later, not only were all shareholders and senior creditors of the banks sacrificed, but large depositors were "bailed in", too.  Like US policymakers just a few years before, EU policymakers were responding to a collapse in confidence with harsher and harsher punishments. 

The swimmers should have known better.

For investors today understanding that the swimmers should have known better may be the most important lesson from 2008 - especially with social mood and economic confidence still very weak.

Should mood deteriorate from here, not only will there be no bailouts, but bailins of greater and greater magnitude will be on offer. 

What happened to shareholders and creditors in Cyprus in 2013 might be the best case scenario going forward, not the worst case.

Public policymakers follow social mood. As mood falls, they adopt "me, here, now, simple" preferences, decisions and actions.  The chronology of events from the summer of 2007 to early 2009 shows how extreme those behaviors can get.

While I don't wish for it, those who don't see the connection between social mood and public policy maker actions are likely to be washed up on the beach in the next storm.

Peter Atwater's groundbreaking book "Moods and Markets" is now available on Amazon and Barnes & Noble.
"Peter Atwater brilliantly provides a framework for understanding both the socioeconomic hubris that led to the great credit bubble of the past decade and the dark social-psychological hangover that has resulted from its collapse. In so doing, he offers an invaluable guide to what promises to be a very difficult and turbulent period ahead as we experience what he calls the 'me, here, and now' behavioral tendencies of the post-crash world."  -Sherle R. Schwenninger, Director, Economic Growth Program, New America Foundation

Twitter: @Peter_Atwater
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