Too big to fail

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Cartoon by Paul Fell

By David M. Walker

Once upon a time, it was believed that AIG, Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers, Merrill Lynch and even Arthur Andersen were too big to fail. However, all these firms have either gone out of business, filed for bankruptcy, been acquired by a rival or been “bailed out” by the federal government.

The related actions by Washington have helped us to avoid a depression and regain some market stability, at least temporarily. They have also come at the costs of trillions in additional federal debt, commitments and contingencies.

As we begin to turn the economy around and take additional steps to stimulate employment, it is worth remembering that there are disturbing parallels between the factors that contributed to the recent mortgage- and debt-related subprime crisis and the already deteriorating financial condition and fiscal outlook of the U.S. government. We must heed and address these disturbing parallels.

The first parallel relates to the dangerous disconnect between the parties who benefit from various practices and those who bear the related risk and ultimately pay the price for the failures of others. In the mortgage area, some parties originated imprudent mortgages to earn certain fees and then disposed of them, thereby imposing losses on others.

In the government’s case, politicians have increased spending, expanded entitlement benefits, including the new Medicare prescription drug program, and engaged in several rounds of tax cuts without considering their long-term costs and related implications. In fact, Washington is trying to further increase health care entitlements even though it already has tens of trillions in unfunded health care promises already.

Second, the mortgage-related subprime crisis was also facilitated by a lack of transparency. Banks and other financial institutions created off-the-books entities so that regulators would find it difficult to track the risks posed to their financial health. Similarly, the federal budget does not reflect the accrued cost of the government’s $43 trillion funding gap for Medicare and Social Security as of Sept. 30, 2008.

Third, there was too much debt, not enough focus on cash flow and overreliance on credit ratings. For example, credit rating agencies rated securitized mortgage packages as high in quality without adequately looking at the weaknesses of the underlying mortgages. In similar fashion, the “expectations gap” regarding investments in Fannie Mae and Freddie Mac instruments, especially by Japan and China, resulted in their demanding that the government step in to stem their losses. The result is that the American taxpayer will now have guaranteed about $5 trillion in such instruments. Only time will tell what the ultimate price tag will be.

Finally, it is now clear that players in both the public and private sector, including corporate boards and federal regulators and oversight entities, failed to mitigate related risks in the face of clear and compelling warning signals. Too many people were asleep at the switch and waited until a crisis was at the door before they acted.

Are there lessons to be learned from recent market disruptions and government interventions? The answer is “Yes.” Beyond the current crisis relating to U.S. financial institutions and homeowners, and the related adverse short-term consequences for our economy, there is a “super subprime crisis” brewing in Washington that the Obama administration and Congress must begin to address. Specifically, existing federal fiscal policies create a troubling disconnect. Today’s taxpayers benefit from the government’s current high-spending and low-tax policies, while their children, grandchildren and generations yet unborn are expected to pay the bill—with interest.

Washington is running large and growing deficits and our nation’s debt burdens are mounting. However, the truth is that our real challenge is not today’s deficit and debt levels—it’s where we are headed based on our current “do-nothing” fiscal path.

In recent years, Washington has tended increasingly to charge the nation’s credit card for a range of spending and tax actions. Wash­ington’s imprudent, unethical and arguably even immoral behavior is facilitated by a lack of adequate transparency and accountability for today’s financial commitments and fiscal practices.

Medicare alone represents $36 trillion of our nation’s $56-trillion-plus federal financial hole as of Sept. 30, 2008. The total federal financial hole number as of Sept. 30, 2009, will not be known until the spring of 2010. Based on information released to date, it’s expected to be over $60 trillion and growing. And that doesn’t include the commitments relating to the Federal Reserve and the Government-Sponsored Entities (GSEs), which likely involve trillions more.

Irrespective of the size of the federal hole, Medicare’s hospital insurance program is already paying out more than it takes in, and the related Medicare “trust fund” is set to run dry within 10 years. And overall health care costs are out of control! The combined Social Security program is expected to run a negative cash flow in 2010 and 2011 due to the recession, and the combined program is expected to be in a recurring negative cash-flow position in less than 10 years. Given these and other factors, the federal government’s current triple-A credit rating may be at risk if Washington does not move to address its growing structural challenges and put its financial house in order soon.

What needs to be done? First, we need more truth and leadership from President Obama and Congress. They must begin to work on a bipartisan and nonideological basis to fight for America’s and our families’ futures. Washington policymakers need to reimpose tough budget controls, constrain federal spending, decide which of President Bush’s tax cuts will stay and which will go, and comprehensively reform our entitlement programs, health care and tax systems. A bipartisan commission that would engage representative groups of the American people with the facts, the truth and the tough choices, and then make related recommendations for a guaranteed vote by the next Congress, is needed to help avoid a “super subprime crisis.”

In addition to a range of policy reforms, we need to modernize the federal government’s accounting approaches and operational practices. Waste in the federal government is huge, results are subpar, transparency is inadequate, and accountability is lacking in far too many areas.

While the U.S. government is truly too big to fail, following our current fiscal path will ultimately have serious adverse implications for our economy, international standing, relative standard of living and, potentially, our national security and domestic tranquility over time. We must not allow this to happen. The sooner Washington acts, the better, since time is working against us. Our country, children and grandchildren deserve no less.

Immigration in Nebraska