Guiding Domestic Finance
Image by Chris Lake
Under Secretary Robert Steel, ’84, talks with dean Edward Snyder about his work at the U.S. Treasury, the crisis in subprime lending, and the role of financial services in globalization.
Snyder: Would you recap your career after you graduated from Chicago Booth?
Steel: I have spent my career at Goldman Sachs—almost three decades. There I enjoyed several different careers: one in Chicago, one in London, one in New York. Also, I had a career in sales, in beginning businesses, and in management and planning. When you’re in an industry and an organization that’s experiencing growth, it creates all kinds of opportunities that you never could have imagined. Goldman Sachs did that for me.
Snyder: Tell me about your time in London.
Steel: There was a period in the mid-1980s when Europe was struggling to find the right economic model. One of my personal heroes is Margaret Thatcher, whose philosophy was that the economy should be unburdened from the yoke of government, and who started on a very forward-looking privatization campaign. As part of that, Goldman Sachs wanted to be more supportive of privatizations, and I moved to London to work in equity capital markets but with a focus on privatization.
The fire Mrs. Thatcher lit spread in Europe, so I was busy with privatizations for several years beginning in 1988. It was exciting. As Mrs. Thatcher said, business does best when we have the freedom to fail. That was the lynchpin of her philosophy.
Snyder: And you became one of the world’s leading experts in the practice of privatization.
Steel: That might be overstating it, but our team worked hard on a lot of privatizations with a great group of people. We worked in England, Spain, Germany, France, Scandinavia—many different countries. Some had a more budgetary commitment to privatizations, others had a more philosophical commitment, including Mrs. Thatcher.
Snyder: You mentioned the geographic scope. Can you talk about the sectors you were involved in?
Steel: In addition to the United Kingdom, we did a lot of work in Spain. Its economy was heavily controlled by the government; they did a series of privatizations in telecommunications and power so these could be competitive companies.
Snyder: Were there any big insights that you reached about that process? Did you confirm Mrs. Thatcher’s view that the best thing to do is to get businesses in the position where they could fail?
Steel: Yes, when government stays out of the way and gives people the ability to work hard and be creative, amazing things can happen. In general, there’s a higher rate of return on assets when managed and led by the private sector. Many things government does aren’t rate-of-return driven, so it’s not a completely fair analogy, but when you have the ability to push things toward the private sector, there are often many benefits to be gained. Sometimes government isn’t naturally comfortable with things like innovation and efficiency, and doesn’t always have the right mechanisms to encourage these positives. There are certain government activities that aren’t measured in quite the same way: safety, social, and conscience issues, for example. But if there isn’t a general push toward creativity, innovation, and efficiency, over the long term the economy will suffer.
Snyder: You mentioned Margaret Thatcher being someone who influenced your thinking. Going back to your Chicago days, was there an influence from your MBA experience?
Steel: I didn’t have a mindset toward an analytical approach, so I found the ideas of linear programming, and how series relate, and statistics with Harry Roberts quite helpful.
As one becomes more interested in planning and managerial issues, these skills become even more valuable. Look at what’s happened in finance. When I started at Goldman Sachs in 1976, there were few derivatives aspects to the capital markets, so you didn’t need to understand the concepts of derivatives very clearly. Today you’re not as well positioned if you’re not comfortable with more sophisticated financial relationships, for which Chicago gives a terrific foundation. I’ve always liked the analogy that the GSB gives you tools you can apply to any situation. At Chicago, I picked up many tools, especially on the analytical side, that I had not developed in my undergraduate program. I had a liberal arts background, so Chicago really let me burnish another side of my potential.
For me, the most enjoyable were all the investment classes: Jim Lorie’s, Merton Miller’s. That was like dessert for me; I found it interesting and just plain fun.
Snyder: Your experience in privatization put you at an important intersection between finance and public policy. Was that part of the backdrop for your involvement with [Harvard’s John F.] Kennedy School [of Government]? It might seem unusual for a partner at Goldman to decide he wants to be involved in a significant way with the Kennedy School.
Steel: Goldman Sachs has a pretty long tradition of encouraging people to engage in all parts of life outside the firm. Consider many of the people who led the firm while I was there: John Whitehead, former deputy secretary of state; Bob Rubin, the first head of the National Economic Council and then secretary of the treasury; Steve Friedman, former head of the National Economic Council and now head of the president’s foreign advisory force on intelligence; Jon Corzine, ’73, former U.S. senator and New Jersey’s current governor; and Hank Paulson, secretary of the treasury. There’s a tradition from the top of being interested in public service and the world outside 85 Broad Street.
I decided to leave Goldman Sachs full time in 2004. A colleague from Goldman Sachs had been working on a class at Harvard and invited me to join him. We co-taught that class for two years, which was a lot of fun. We talked about the economic aspects of public policy and looked at issues, whether it was Social Security or Medicare/Medicaid or Basel, as financial and public policy issues. Public policy schools and business schools have their respective lenses on these issues and we tried to bring them closer to the middle. These are challenging economic issues with a big public policy effect. It was a comfortable transition from Goldman Sachs to think about these issues, and it served as a nice—and completely serendipitous—transition to this job.
Snyder: How did you end up in this job?
Steel: Secretary Paulson called in late June 2006. He and I had been close associates for almost 30 years. I joined Goldman Sachs in 1976 in Chicago and the secretary also worked in the Chicago office, having joined the firm about a year earlier. We were on the 60th floor of the Sears Tower, when that was a new building, and the office had less than 100 people. There are different divisions of the firm, but in a regional office you can’t help but know each other. Over the years, he has been my associate, my partner, and my boss. I’ve always had tremendous respect for him. So when he called and suggested there might be a way that I could help at Treasury, I was quite honored.
Snyder: So this was a clear-cut decision for you?
Snyder: Your position is principal adviser to the secretary on matters of domestic finance; you also lead the treasury’s activities with respect to the domestic financial system, fiscal policy and operations, government assets and liabilities, and related economic and financial matters. Is that accurate?
Steel: We’re responsible for three areas in domestic finance, each led by an assistant secretary. They are financial institutions, financial markets, and one area called fiscal affairs.
One large responsibility of the fiscal affairs area is preparing the financial statements for our government. In mid- December we produced the government’s annual report. Think about it: our fiscal year ended in September. This is the largest, most complex, most challenging organization in the world to describe and we issued statements within 90 days. In fiscal affairs, we also manage the daily cash flow for the entire U.S. government.
Snyder: How often do you issue securities?
Steel: Constantly, the shorter ones more frequently. We’re also constantly monitoring the cash flow and estimating what might be needed so we can adjust the dials. We have a game plan, but we have to be flexible. But we have a template, and it’s important that the government be seen as a predictable and consistent issuer. That’s crucial. When you’re the size we are, and seen as the benchmark of confidence and quality, predictability and consistency are the key. If we want to make adjustments, we must be very careful to communicate what we’re trying to do and why we’re doing it. As an issuer, Treasury has a different responsibility to the whole marketplace.
The other two areas—financial institutions and financial markets—focus on policy. Are the markets working correctly, are there challenges in the marketplace, and with the financial institutions, are there issues that we need to be aware of? We consider many issues. For example, we’ve worked very hard along with a lot of other regulators to be an advocate for the United States adopting the updated Basel II Framework for financial institutions. Another issue is making sure public policy is addressing things like private pools of capital, hedge funds, private equity, venture capital. With an industry that is really just a couple of decades old, how should we regulate it?
Snyder: On the policy side, what has been a big surprise since you’ve gotten here?
Steel: Policy is interesting. Some things are the responsibility of the executive branch, while other initiatives require working with Congress. It’s easier to coordinate when it’s Treasury alone; it becomes more sophisticated and complex when we work with Congress, and that’s been a new experience for me. Since Secretary Paulson has been here, we’ve had a constructive relationship with Congress and we’ve collaborated on the key issues. Our system is designed to have checks and balances, to make sure that a temporary perspective of the day doesn’t get overdeveloped and collect too much authority.
Snyder: Regarding the subprime issue, dealing with the cause and regulating the process of generation of mortgages lies with the Fed. But dealing with how it affects financial markets, is that more the Treasury?
Steel: A lot of people work on that. I think there are three issues. There is the issue of how the markets are behaving at any point in time. That’s primarily the responsibility of the Federal Reserve; they have authority for monetary policy. The second issue is keeping homeowners in their homes. Treasury is a key player in that, and so is the Federal Housing Administration, which is part of the Department of Housing and Urban Development. The third issue is asking what are the areas of market practice or areas of consternation—you and I would say transparency, complexity, rating agencies, mortgage origination, securitization, and on– and off–balance sheet issues. Our plan here in Washington is to focus on the markets and the homeowners, and in the months ahead we’ll examine the longer-term policy aspects and determine the lessons we’ve learned.
On homeownership and mortgages, the United States has the most developed model of homeownership in the world. Many attractive things are normally associated with homeownership. Economists have written that homeowners tend to save more, invest more in their children, build more wealth, and are more active in their communities. In America we have about 55 million mortgages. Of those, about 93 percent or 51 million households are paying their mortgages on time.
The mortgage process has developed over time. For many years, you went to the S&L to get a mortgage and you could only pay one rate for 30 years, fixed. That worked well in some ways but, as Chicago would teach us, it had other unintended consequences. People with the strongest credit history got first access to credit, and banks couldn’t charge a risk premium to loan money to someone who might have less than perfect credit history. So, homeownership focused on a certain class of person. People who were new in getting credit or who might have had a blemish on their credit record were not able to access credit.
In the 1990s, practices changed. Lenders could charge a premium rate, over the less risky rate, and suddenly homeownership began to rise for minorities and people who were not as clean from a credit perspective. This was the first application of subprime lending. It had very good effect.
In 2004, after a long period of home price appreciation and strong demand, we began to have a slowdown in housing and demand for loans declined. Subsequently, people who manufactured loans, in order to maintain a consistent volume, began to lower their standards and use more aggressive techniques to encourage people to pursue homeownership. That set a standard and originators used new products, such as loans that had an introductory interest rate for the first two years fixed and then reset to a higher rate for the remaining 28 years. That set up a new group of homeowners and created the challenges of today. When you say “subprime” today, there’s a chilling effect, but if you go back over the last decade, subprime products have enabled many families to enjoy the benefits of homeownership. Even today, of the 7 million outstanding subprime mortgages, about 5 million—74 percent—are being paid on time. It warrants understanding beyond the headlines.
Now the challenge is with groups of loans that were made over the last few years where people were less qualified. There are three things behind this challenge. First, there were some practices by the lenders that were predatory in nature, and we should be completely against predatory lending; that’s wrong. Second, some borrowers were too aggressive and stretched too far beyond their means; that happens all the time. In an average year, when things are going well, we have 600,000 or 700,000 foreclosures. Not everyone is successful at their first attempt to buy a home. Third, after ten years of house appreciation, people thought the optionality of owning a home was only positive. If you took a behavioral finance perspective, everyone took recency and extrapolated it when in fact that’s what we learn you shouldn’t do. These are the three ingredients, and I’m uncomfortable when someone assigns complete accountability to one piece. It will become clearer over time what factor should be assigned what value, but those are the three factors in the equation.
Snyder: As you said, with a lot of people “subprime” is a button people push. Your analysis makes a distinction in terms of timeline and brings in a cost-benefit analysis. There are many significant benefits to homeownership, and when you go from the old days, as you said, from 30-year fixed mortgages for everybody, it’s like wooden shoes for everybody. As Gary Becker points out when dealing with policy, given that there are benefits to home ownership, the optimal number of foreclosures isn’t zero.
Steel: We are all familiar with the concept of frictional unemployment. It’s always changing—people are going through it, but there’s a level of unemployment that’s characteristic of the economy. And there’s a level of frictional foreclosure that’s characteristic of a housing stock of 55 million mortgages. The idea that foreclosure should be zero is something I think Gary Becker would agree is not appropriate. I think we have to be careful on limiting products. A young person who thinks his income is rising dramatically over the next few years may want to live with a lower payment today because he expects it to improve. It’s a tricky public policy issue to get too much into prescribing what products can be offered to people. If we’re not careful, if the creativity and the innovation are limited, there will be a reversion to when credit was more available to people of means than to people of less wealth. And helping people get their foot on that first rung of borrowing and using credit appropriately is a good thing.
Snyder: I couldn’t agree more. You get into the law of unintended consequences. You mention a very interesting point about the person who believes he or she has a very positive income profile. That’s a different kind of option that doesn’t depend on the housing market going well; it depends more on the belief that the individual is going to do well. That’s an issue of personal freedom.
Steel: I’ve seen a couple of these situations — tech investing in the late 1990s, or homeownership — where the pervasive perspective is one way and the presumption is that if you’re not part of it, you don’t get it.
Snyder: It’s important to collect the facts, and I’ll tell you what I find difficult about the housing issue as an example. Look at the magnitude of the problem, in terms of the potential downward pressure on the housing markets that you articulated, as sort of a Main Street issue. It hits schools and savings and has social dimensions. There’s uncertainty about how big a Main Street effect it is. On one hand, you might think it’s people who bought their house recently in a certain type of mortgage category; and on the other hand, the magnitude that relates to downward pressure could be a lot greater if it’s people who have done a lot of refinancing. Can you get the facts that you need? How do you bring them to bear knowing there’s a lot hitting you in a short period of time?
Steel: There’s a permanent economic policy group at Treasury, headed by assistant secretary Phil Swagel, that understands these issues. It’s not just about gathering facts. It’s about starting with a neutral point of view and wanting to gather information without value ascribed to it. I think some people come to these issues with a policy perspective first and look for data that are complementary to their perspective. The right thing is to assume that facts are neutral, gather the appropriate ones, and evaluate them for the best policy. That doesn’t mean that we don’t all have individual philosophies about policy; we do. If you take a Warren Buffett approach of trying to make it simple to begin with, and build up from a simple model that you really understand, then the gymnastics of figuring out where to go and how to do it become clearer. To do that, you have to have your building blocks in order. I ask myself how I would describe this issue to a really smart friend who’s, say, a surgeon. How would you describe that issue to him?
Snyder: Can you comment on your assessment of the global implications of this situation? In Europe, there’s a tremendous curiosity about how mortgage issues in the United States could implicate sophisticated financial institutions around the world. There’s curiosity about the mechanism as well as a lot of concern about liquidity, the hits that some financial institutions are taking, and the implications in terms of the funding that certain institutions are getting from some surprising sources.
Steel: I’ve seen two shifts in my 30 years that I will most remember. One is technology in business and financial services, and the other is the global nature of all markets. We know we live in a global world, and one of the leaders in its factor of global nature is financial services. It’s hard to think of other industries where the product can move instantaneously with a push of a button anywhere in the world. The other big change in our lifetimes is that when you and I were growing up, there was a debate about forms of government and economy. There were people who believed that a state-managed economy could produce a higher standard of living with lower inflation and lower unemployment than a market-oriented economy. Today that debate is pretty much over. Notwithstanding North Korea and Cuba, and, I guess, Venezuela—though they are having second thoughts—wherever people were 20 years ago, they’re more to the market side now. Very few people have moved more to the state side of that question.
I think a key lubricant to this change is financial services. Simultaneous with that change is more direct involvement of more modern financial services. So this trend over the last 30 years means that things you and I grew up learning about—communism, totalitarianism—are like words from the past. Today, with this greater acceptance of a more market-oriented economy at the margin, it raises the importance of financial services. How does that affect us? Investors think globally, financial institutions think globally—there really isn’t a border; it’s almost a foreign concept for much of financial services.
Snyder: You’ve reminded me of this George Will comment that I love. After the fall of the Soviet empire in 1989, he wrote a column that said, “The Cold War is over; The University of Chicago has won.” And you’re right, we’re talking about shades of gray within a range for most countries. Market-oriented economies.
Steel: But it’s just at the margin, that’s the direction. I don’t hold up ours as the way everyone should do things. They should find their own way of having their people decide what they want to own and buy and invest and do.
Snyder: But you’ve made a strong case that financial services are a critical element in the functioning of economies.
Steel: I believe as economies want to move in this direction, people have to be assured that financial services work. If they don’t, they can’t trust a banking system and they don’t have an efficient way to save, invest, and plan for their retirement.
Snyder: I’ve had a debate with some of my colleagues at Chicago. One side is the view that we could have dysfunction in the global financial markets for some period of time because of the lack of confidence. And the other is that even if we have some disruptions, people will work it out because the gains of trade are so great. Plus entry and innovation will win the day. Where are you on that?
Steel: Nothing is absolute, but you know the history is pretty replete with economies — I believe flexible is the word Alan Greenspan used to describe the economy — that can work through lots of things. The key issues are transparency, so people understand, and liquidity, so the system can work. Lastly, the financial institutions have to be well capitalized so they can work through periods of disruption.
Snyder: Are you having fun on the job?
Steel: I’m glad I’m doing it. It’s a real privilege and an incredibly interesting job. The secretary and I talked about this at a quiet moment. Having a job like his is very challenging. A stint in government gives you a lot of respect for the commitment of the handful of people who have these really difficult jobs. I don’t think I’ll ever have a mean-spirited reaction to anyone in government again. I may not agree with them, but we must be respectful of them. They’re very challenging jobs and they give it their all, not just in this administration but in others. And I respect them for that.