Federal Reserve documents 21 page

Moreover, because of the enormous losses that AIG would incur in the following quarters, the deal would have to be restructured several times. Ultimately the U.S. government (the Fed and the Treasury combined) would make investments and loan commitments totaling $182 billion to prevent AIG from failing. At the time of our initial rescue of AIG, I kept my emotions in check and tried to view the situation analytically, as a problem to be solved. But, once I fully understood how irresponsible (or clueless) AIG’s executives had been, I seethed. “It makes me angry. I slammed the phone more than a few times on discussing AIG,” I would later say in a television interview. “I understand why the American people are angry. It’s absolutely unfair that taxpayer dollars are going to prop up a company that made these terrible bets . . . but which we have no choice but [to] stabilize, or else risk enormous impact, not just in the financial system, but on the whole U.S. economy.”

Looking back now, I am only partly consoled by the fact that the government ultimately recouped all that it invested in AIG, and more. The Fed and the Treasury realized a combined gain of nearly $23

billion. That’s a testament to good work by the company’s new leaders—including CEO Robert Benmosche, who followed Liddy—and the Fed and Treasury teams that monitored AIG after our loan was made. But, importantly, it was also because our interventions would ultimately stabilize the financial system, allowing AIG and other financial institutions to find their footing.

In a remarkable demonstration of chutzpah, former AIG CEO Hank Greenberg, as head of the investment vehicle Starr International Co., which owned a substantial stake in AIG, would file a $25 billion lawsuit three years later accusing the U.S. government of imposing unfairly punitive terms in the bailout. He made this argument despite the fact that AIG’s own irresponsible actions were the source of its predicament, and despite the fact that the AIG board voluntarily accepted the Fed’s terms, recognizing that bankruptcy would leave the shareholders with nothing. As it turned out, because of the bailout, the AIG shareholders eventually regained control of a profitable company. Thousands of other companies, like Thornburg Mortgage, did not receive similar help during the crisis and failed as a result.

LEHMAN WEEKEND, WHICH ultimately became Lehman-AIG week, transformed a year-old crisis, already exceptionally severe, into the worst financial panic in our nation’s history. Because Lehman failed but AIG was saved, questions persist. Did the government make a conscious decision to let Lehman fail, and, if so, why did it go on to save AIG? Additionally, if Lehman had somehow been saved, would a substantial part of the ensuing crisis have been averted?

Many have argued that Lehman could have been saved, as Bear Stearns had been and as AIG would be, and that letting Lehman go represented a major policy error. Yet the Fed and the Treasury did not choose to let Lehman fail. Lehman was not saved because the methods we used in other rescues weren’t available. We had no buyer for Lehman, as we’d had for Bear Stearns—no stable firm that could guarantee Lehman’s liabilities and assure markets of its ultimate viability. The Treasury had no congressionally approved funds to inject, as they’d had in the case of Fannie and Freddie. Unlike AIG, which had sufficient collateral to back a large loan from the Fed, Lehman had neither a plausible plan to stabilize itself nor sufficient collateral to back a loan of the size needed to prevent its collapse. And Lehman’s condition was probably worse than reported at the time, according to the bankruptcy examiner’s report in 2010. As we would learn, the company used dubious accounting transactions to inflate its reported ratio of capital to assets. It also significantly overstated the cash it had available to pay creditors. Ultimately, in bankruptcy, Lehman’s bondholders would receive only about 27 percent, and its other unsecured creditors only about 25 percent, of what they were owed. Total losses to creditors have been estimated at close to $200 billion.

Some have contended that converting Lehman into a bank holding company overnight, as was done later for other investment banks, could have saved it. But that wouldn’t have solved its problems. Lehman already could borrow short-term from the Fed through the Primary Dealer Credit Facility. A short-term infusion of cash wouldn’t have been enough. Given the size of its losses, it needed to find a buyer or a

major long-term investor, or a consortium of investors. Fuld had been unable to attract major investors in months of trying, and none were to be found on that final, fateful weekend.

If a means of saving Lehman did exist, given the tools then available, we were not clever enough to think of it during those frenetic days. Dozens of people were involved in both New York and Washington, and no one has ever reported a meeting or a call in which Hank, Tim, or I discussed whether or not to save Lehman—as we did, for example, with both Bear Stearns and AIG. We already knew Lehman needed to be saved. We lacked the means to do so.

I understand why some have concluded that Lehman’s failure was a choice. In a way, it is a sort of backhanded compliment: We had shown such resourcefulness to that point, it is hard to imagine that we could not have come up with some solution to Lehman. Even a few participants in the September 2008 FOMC meeting, such as Jim Bullard of the St. Louis Fed, Jeff Lacker of Richmond, and Tom Hoenig of Kansas City—none of them involved in the discussions over Lehman weekend—inferred, approvingly, that letting Lehman go was a choice rather than an unavoidable outcome.

Paulson’s declarations that no government money would be used to save Lehman, both before and during the weekend, also understandably fuel the belief that we chose to let Lehman fail. Hank had various reasons for saying what he said, including his personal and political discomfort with becoming the face of unpopular bailouts of too-big-to-fail institutions. However, I am sure that tactical considerations were an important motivation for his statements. We very much wanted the private sector to take the lead in rescuing Lehman, either through an acquisition or through a consortium of private-sector firms. But the private sector would have little incentive to incur the costs of a solution if they were sure that the government would ultimately step in. Hence the need to talk tough. Finally, Hank’s statements were to some extent beside the point, in that Fed loans were the only government funds available. It would have been the Federal Reserve’s decision—not Hank’s or the Treasury Department’s—whether to make a loan, had a loan of sufficient size to save the firm been judged feasible.

In congressional testimony immediately after Lehman’s collapse, Paulson and I were deliberately quite vague when discussing whether we could have saved Lehman. We spoke about the true, but ultimately irrelevant, fact that financial firms had more time to prepare for Lehman’s collapse than for a Bear Stearns failure. But we had agreed in advance to be vague because we were intensely concerned that acknowledging our inability to save Lehman would hurt market confidence and increase pressure on other vulnerable firms. Today I wonder whether we should have been more forthcoming, and not only because our vagueness has promoted the mistaken view that we could have saved Lehman. We had good reason at the time to be concerned about runs on Goldman Sachs and Morgan Stanley and possibly other firms. Nevertheless, our caginess about the reasons for Lehman’s failure created confusion about the criteria for any future rescues. Would it have been better for market confidence to have admitted that we were unable to save Lehman? Or was it better to maintain ambiguity, as we did, which suggested we still had the capacity to carry out future interventions? I don’t know.

While we did all we could to save Lehman, I feared at the time that avoiding the firm’s failure might only delay the inevitable. Today I’m confident that my instinct was right. By Lehman weekend, the ability of the Fed to keep rescuing major financial firms, alone and without support from Congress, was fast coming to an end. As Bill Dudley had emphasized to the FOMC, the Fed’s balance sheet could not expand indefinitely without compromising our ability to implement monetary policy. More importantly, though, political tolerance for what Milton Friedman’s former coauthor Anna Schwartz called the Fed’s “rogue” operations had reached its limits. In short, even if it had somehow been possible for the Fed on its own to save Lehman, and then perhaps even AIG, we would not have had either the capacity or the political support to undertake any future financial rescues.

Even as we came to the end of our resources, the increasingly evident weakness of the system—losses still to come, lack of capital, evaporating confidence—went well beyond Lehman. The United States had had several very bad hurricane seasons in the previous years, and on Lehman weekend I imagined a series of hurricanes coming up the coast, one after the other. But these hurricanes, rather than being named Katrina or Rita or Gustav, were named AIG and Merrill Lynch and Morgan Stanley and Goldman Sachs and Washington Mutual and Wachovia and Bank of America and Citigroup and . . . How could the Fed hope to deal with this colossal crisis on its own, with no remaining tools and no political support? As I said on conference calls over Lehman weekend, we should stop fooling ourselves: The time had come to go to Congress. There was simply no historical precedent for solving a financial crisis of this magnitude without significant taxpayer dollars and the political will to undertake the effort.

As it turned out, even the risk of a once-in-a-century economic and financial catastrophe wasn’t enough for many members of Congress to rise above ideology and short-run political concerns. Despite the chaos that followed Lehman’s failure and the obvious implications for the economy, Congress would need more than two weeks and two tries to pass legislation that ultimately provided the money necessary to stop the crisis. It seems clear that Congress would never have acted absent the failure of some large firm and the associated damage to the system. In that sense, a Lehman-type episode was probably inevitable.

If historians eventually agree that saving Lehman would not have avoided subsequent failures, the intensification of the crisis, the resulting recession, or the need for hundreds of billions of taxpayer dollars from Congress, then perhaps the question of whether the company’s collapse that weekend was avoidable will become moot. Nevertheless, I do not want the notion that Lehman’s failure could have been avoided, and that its failure was consequently a policy choice, to become the received wisdom, for the simple reason that it is not true. We believed that Lehman’s failure would be extraordinarily disruptive. We did everything we could think of to avoid it. The same logic led us to rescue AIG, where (unlike for Lehman) our makeshift tools proved adequate.

CHAPTER 14

We Turn to Congress

Newspapers on Wednesday, September 17, splashed the rescue of AIG across their front pages in type usually reserved for declarations of war. The political and media worlds were trying to arrive at a conventional wisdom on the events of the past few days, and the early returns did not favor us. Most editorialists and economists on Monday and Tuesday had supported what they saw as a principled decision to let Lehman fail. Consequently, many viewed the subsequent decision on AIG as an inconsistent reversal, rather than what it was: a different response to different circumstances.

Even economists generally well disposed to the Fed were critical. “The government drew a line with Lehman and then erased a portion of the line,” said Vincent Reinhart, formerly the director of the Board’s Division of Monetary Affairs, where he had coauthored several papers with me. Adam Posen, another former coauthor who would go on to be a leading policy dove at the Bank of England, wrote, “This is very bad news and it is a very confused precedent. AIG has been bleeding capital and liquidity for months. Anybody in their right mind could have gotten out.” And Carnegie Mellon professor Marvin Goodfriend, a former Richmond Fed economist whom I knew well, said of the Fed, “You don’t have any rules and you are trying to set the rules in the middle of the game.” I was sure we had made the right call, but the hostile reaction from informed observers put me on notice. We were going to have a tough time convincing Congress, the media, and the public. I was also dismayed that some people who had known or worked with me—like Reinhart, Posen, and Goodfriend—seemed disinclined to give us the benefit of the doubt.

Politicians, as usual, tried to have it both ways. On the one hand, they knew that bailouts were intensely unpopular, and many did their best to take advantage of (and reinforce) the perception that the

Treasury and the Fed were putting Wall Street ahead of Main Street. Jim Bunning compared the Fed, unfavorably, to Hugo Chбvez, the socialist Venezuelan dictator. A Dow Jones wire story captured the mood: “For one day at least in this politically charged election season, Democrats and Republicans on Capitol Hill appear to have buried the hatchet. Right into Ben Bernanke.” On the other hand, more thoughtful legislators like Barney Frank realized that they themselves might soon be called upon to make unpopular decisions, and so their comments were more cautious. (However, as usual, Barney could not resist a joke. At a hearing later that week, he proposed that Monday, September 15—the day between Lehman’s failure and AIG’s rescue—be designated “Free Market Day.” “The national commitment to the free market lasted one day,” Barney said. “It was Monday.”)

In the financial world, short-term funding markets were barely functioning. Banks were hoarding cash rather than making loans, and withdrawals from money market funds were accelerating—especially from so-called prime money market funds, which invest in a range of mostly short-term assets, including commercial paper issued by financial and nonfinancial firms. Much of the cash flowing out of prime funds was moving into “government-only” money funds that invested solely in Treasury bills and other government liabilities viewed as ultrasafe. In the three weeks between September 10 and October 1, $439 billion would run from the prime funds, while $362 billion would flow into the government-only funds— an unprecedented shift.

I arrived at work on September 17 around 7:00 a.m. After a long-scheduled breakfast with Florida congressman Connie Mack, great-grandson and namesake of the famous manager of the Philadelphia Athletics, I updated colleagues inside and outside the Fed on the AIG rescue. At 9:45 a.m., joined by Don Kohn, Kevin Warsh, and Tim Geithner, I spoke via conference call to the governors of the Bank of Canada (Mark Carney), the Bank of England (Mervyn King), the European Central Bank (Jean-Claude Trichet), and the Bank of Japan (Masaaki Shirakawa). All of them were pleased that, after the Lehman debacle, we had been able to avoid AIG’s failure. All agreed that the disorderly collapse of another large, interconnected financial firm should be avoided at all cost. I expressed confidence—perhaps more than I felt—that the AIG deal would work.

The aftershocks from Lehman’s failure and AIG’s near miss were pounding financial markets around the world, and each of the governors had increased his bank’s lending in an effort to quell the panic. We also collectively confirmed that the expanded currency swap lines approved by the FOMC on Tuesday would be jointly announced at the opening of business in Europe on Thursday. I told the other central bankers I appreciated their support. It was more than lip service. Each of us was acutely aware of the responsibilities we faced as well as the political and media minefields ahead. We all knew that we would meet those challenges more effectively if we worked together rather than operating in isolation.

After the international call, at Michelle Smith’s suggestion, I briefed the FOMC by videoconference. Michelle had been hearing all morning from frustrated Reserve Bank presidents asking for more information. They were besieged by press inquiries and calls from their board members and needed to

know how to respond. I explained the terms of the loan to AIG and the reasons for it. Tim and Bill Dudley also commented and took questions. I had trouble gauging the presidents’ reaction. Most seemed to appreciate that extraordinary times justified extraordinary measures. But some expressed concerns about the action itself, which looked like an inconsistent lurch, as well as about the political backlash against the Fed that was already building.

Since the Board decides whether to invoke the Section 13(3) emergency lending authority, it was entirely appropriate—and necessary, as a practical matter—to inform the presidents about the details after the fact. Nevertheless, during the videoconference I felt a tension that we dealt with throughout the crisis: I wanted to involve as many of my colleagues as possible, to get both useful advice and greater buy-in. But during this most intense phase of the crisis, at least, the need to move quickly often trumped the benefits of broad consultation.

After lunch, at Michelle’s request, I took calls from reporters. If we were going to hold our own in the court of public opinion, we needed to get our side of the story out. Generally, I spent the most time with the beat reporters who wrote regularly about the Fed, including Jon Hilsenrath of the Wall Street Journal, Greg Ip of the Economist, Krishna Guha of the Financial Times, Neil Irwin of the Washington Post, John Berry of Bloomberg, Steve Liesman of CNBC, and Ed Andrews of the New York Times. I knew that these more specialized reporters were best equipped to understand and then explain what we were doing and why. Other media would pick up on their reporting.

Not that these folks necessarily took what we told them at face value. Wall Street Journal editor and columnist David Wessel once told me that if a reporter was doing a good job, the officials the reporter was covering felt relieved when he or she was reassigned. Some of the reporters I dealt with over the years would have handily met Wessel’s criterion. But overall, I thought we usually received a fair hearing from the beat reporters. We were more likely to see an unfair or inaccurate story from journalists who did not usually cover the Fed and were, consequently, less well informed.

Throughout Wednesday we paid particularly close attention to Goldman Sachs and Morgan Stanley. As the two remaining independent investment banks, they were the subject of intense market scrutiny and speculation. Both companies had stronger franchises and healthier balance sheets than Bear Stearns, Lehman, and Merrill Lynch. But, like the other firms, they needed to find funding every day to finance their securities holdings and to meet demands for collateral. As we now fully appreciated, lenders, customers, and counterparties were reluctant to deal with a company whose stability they doubted. If confidence in the firms continued to decline, we could see the equivalent of a run on one or both of them.

Goldman and Morgan Stanley had long histories. Goldman was founded in 1869 in lower Manhattan by Marcus Goldman, the son of a Jewish cattle dealer in Bavaria. Goldman brought his son-in-law Samuel Sachs into the firm in 1882, and the company prospered into the new century. Goldman Sachs nearly failed after the 1929 stock market crash but recovered under the leadership of Sidney Weinberg, who, after dropping out of school, had started at Goldman as a janitor’s assistant at age sixteen.

Goldman had long been associated with the political establishment. Critics dubbed it “Government Sachs.” Sidney Weinberg was a confidante of FDR, and Presidents Eisenhower and Johnson reportedly followed his recommendations for appointments of Treasury secretaries. Bob Rubin, secretary of the Treasury under President Clinton, had been a top executive at Goldman, as Hank Paulson had been. In the world of central banking, Mario Draghi (governor of the Bank of Italy, later president of the ECB), Mark Carney (governor of the Bank of Canada and, later, the Bank of England), and Bill Dudley (the New York Fed’s markets chief and later president) were also Goldman alumni. Gary Gensler, the head of the Commodity Futures Trading Commission at the time, had also worked at Goldman. Not surprisingly, the close connections have led to concerns about undue influence. I understand the concern. On the other hand, it seems unrealistic to expect government agencies to effectively regulate markets or industries if no one in the agency has relevant experience in that market or industry. I can only say that the Goldman alumni with whom I worked brought not only substantial financial expertise to their government duties, as one would expect, but also a strong dedication to the public interest.

The current Goldman CEO, Lloyd Blankfein, and I had been undergraduates at Harvard together, though I did not know him well there. He then earned a law degree from Harvard and, after a few years of lawyering, went to work for Goldman as a precious metals salesman in London. He had grown up in a housing project in Brooklyn; his father sorted mail at the post office and his mother was a receptionist for a burglar alarm company. During my time as chairman I met with Blankfein occasionally to discuss issues related to Goldman and to hear his views on the markets and the economy. Lloyd was obviously very bright, and I found his insights into market developments particularly useful. That said, I intentionally avoided developing close personal relationships with anyone on Wall Street, not only because of the Fed’s regulatory responsibilities, but to avoid being influenced by the groupthink that seemed too often to develop in the financial halls of power.

Morgan Stanley was born of the breakup of J.P. Morgan & Company in 1935, after passage of the Glass-Steagall Act forced the separation of commercial banking (making loans) and investment banking (underwriting stocks and bonds). J.P. Morgan’s grandson, Henry Morgan, and Harold Stanley, a J.P. Morgan partner, lent their names to the new firm, which instantly joined the ranks of Wall Street’s elite. In 1997, in a departure from its traditional business, the firm merged with the retail brokerage Dean Witter Reynolds, acquiring the Discover credit card franchise in the process. But Morgan remained engaged in underwriting and trading securities. It became the biggest U.S. securities firm by market value in 1998, although its earnings recovered less quickly from the dot-com crash than those of other firms. After a series of power struggles, John Mack, a long-time Morgan Stanley executive, became CEO in 2005.

Mack, the sixth son of Lebanese immigrants (the family name was originally Makhoul), grew up in Mooresville, North Carolina, where his father ran a general merchandise store. He attended Duke University on a football scholarship. Mack was seen in the industry as aggressive and charismatic; in the period before the crisis he boosted Morgan Stanley’s profits by increasing risk and taking on more debt.

Kevin Warsh, whose first job had been at Morgan Stanley, followed the firm closely and kept us apprised of developments.

MEANWHILE, WASHINGTON MUTUAL’S troubles finally were coming to a head. It had been on death watch for months, but disagreements between the Office of Thrift Supervision and the Federal Deposit Insurance Corporation had delayed the resolution. FDIC chairman Sheila Bair pressed WaMu to sell itself, notwithstanding continued resistance from the OTS, which believed the company could survive on its own. JPMorgan Chase seemed the most likely acquirer, but several other firms had also expressed interest. It looked like negotiations would wrap up over the weekend.

We were also getting worrisome reports about Wachovia. The bank had been underperforming for several years. In June, its board had ousted its CEO, Ken Thompson. Ken, a smart, gregarious native of Rocky Mount, North Carolina, where he was a star athlete in high school, had spent his entire career at the bank, starting thirty-four years earlier at a predecessor institution, First Union Corp. I got to know Thompson during the time he sat on our Federal Advisory Council, and he struck me as knowledgeable and thoughtful. But he had made the same mistake that many of his peers had made, aggressively pushing his bank into risky real estate lending. In 2006 Wachovia acquired Golden West Financial Corporation for $25 billion and inherited a portfolio of mostly lower-quality residential mortgages. Golden West had popularized the option adjustable-rate mortgage, which initially allows the borrower to make payments so small that the loan balance can grow rather than shrink. Wachovia’s merger with Golden West and Bank of America’s acquisition of Countrywide were strikingly similar. Wachovia had also expanded strongly in commercial real estate and construction lending. But now the losses and markdowns were accumulating, and Wachovia watched as its uninsured funding melted away.

I WAS GROWING weary of putting out fires one by one. We needed a more comprehensive solution to the crisis, and that meant asking Congress for taxpayer dollars. I had made that point on calls over the weekend, during discussions of Lehman and AIG. Wednesday evening, on a call with Hank, Tim, Chris Cox of the SEC, and others, I pressed the point again. The Fed couldn’t do it alone. As we looked ahead, many major financial institutions, and indeed the entire economic and financial system, were at serious risk. To secure the necessary authority, the fiscal firepower, and the democratic legitimacy needed to stop the crisis and avoid unthinkable outcomes, we had to go to Congress.

Hank was initially noncommittal. He knew that he and his team would have to lead the effort to develop a legislative proposal and sell it to Congress. It would not be easy. The bailouts had angered the voters and thus the politicians. Main Street had not yet even felt the full effect of Wall Street’s woes. But the alternatives all seemed worse. By Thursday morning Hank would come around to the view that we could not hope to contain the crisis without help, and he agreed to seek legislation.

Chris Cox, meanwhile, wanted to ban short-selling of financial company stocks. John Mack, like Dick

Fuld of Lehman before him, had complained that short-selling was threatening to destabilize his company. Stop short-selling, Cox suggested, and we would remove one threat to firms under pressure.

Paulson seemed prepared to support Cox. I had doubts. Short-selling is part of how a healthy market determines prices. A trader who is optimistic about a company buys its stock. Short-selling the company’s stock is a way for a pessimist to express a contrary opinion. Short-sellers, at times, are the sharks in the financial ocean: They thrive by preying on the weakest companies. That’s normally healthy for the ecosystem—it allows stock prices to reflect a full range of views. On the other hand, these were hardly normal times. I wanted to think about it. I was pleased to learn on the call that Mack was in serious talks with the Chinese sovereign wealth fund, for a second investment on top of its investment in December 2007, and a Chinese bank. Raising capital would be the best way for Morgan Stanley to restore market confidence.

Thursday, September 18, was another tough day, but it proved to be a turning point. Inauspiciously, it began at a gastroenterologist’s office. He wondered if my stomach upset might be caused by stress. More encouraging was an email from the baseball statistics genius Bill James, relayed by Chuck Blahous, an economic adviser in the White House. “Tell Ben to hang in there,” James wrote. “At some point the people who are saying it can’t get any worse HAVE to be right.”

The expansion of currency swap lines with other major central banks had been announced. All told, adding together the limits of the swap lines, we stood ready to provide nearly $250 billion to calm dollar funding markets around the world.

Calls with Treasury and the SEC filled the morning and early afternoon. Cox again pushed to ban short sales of financial stocks. Pressure on the stock prices of Morgan, Goldman, and other firms seemed to be growing, some of it likely coming from short-sellers. Although I still had lingering doubts, I agreed not to oppose a temporary ban. Cox would take the idea back to his commission for consideration.

Date: 2016-04-22; view: 594