Federal Reserve documents 22 page

We discussed the money market funds at length. Even some of the largest, best-known money funds were reporting significant outflows. The runs had the potential to inflict serious economic damage, not only by adding to the market panic but also because many large corporations depend on money funds to buy their commercial paper. A pullback by the money funds would hurt the ability of companies like General Electric or Ford to finance their daily operations. We were already hearing that only the highest-rated firms could sell commercial paper, and even these for terms of only a day or two. Meanwhile, firms shut out (or worried about being shut out) of the commercial paper market drew down their bank lines of credit, putting additional pressure on cash-short banks and making them even less willing to lend to other customers. Financial turmoil was now having clear and demonstrable effects on the nonfinancial part of the economy, threatening production and employment.

We needed to stop the bleeding. The Board, the New York Fed, and the Boston Fed had been working on a new facility to provide the money market funds with the cash they needed to pay off their investors. But it was technically and legally complicated. Rather than lending directly to the money funds, we would

lend to banks on favorable terms, on the condition that they purchase less liquid asset-backed commercial paper from money funds—a significant share of the assets held by the funds. That would funnel cash to them, without violating legal restrictions on the Fed’s purchasing securities directly from the money funds.

On the call that morning, Paulson proposed also using Treasury’s Exchange Stabilization Fund to guarantee the money market funds, much as the FDIC guarantees ordinary bank deposits. If investors in the funds believed their money was safe, they would have no reason to run. I thought this idea was excellent. The Exchange Stabilization Fund was created during the Depression to allow the Treasury to manage the dollar’s value in foreign exchange markets. (If the Treasury wanted to curb a rapid increase in the dollar’s value, for instance, it would sell dollars and buy euros or yen, thus increasing the supply of dollars. If it needed to slow a fall in the dollar’s value, it would sell euros or yen to buy dollars.) While what Paulson was proposing was not an intervention in the foreign exchange market, in the past the fund had been used for purposes only indirectly connected to managing the dollar’s value. Most notably, it was used in 1995, when Bob Rubin and Larry Summers were leading President Clinton’s Treasury Department, to lend $20 billion to Mexico to help stabilize the plummeting peso.

Because money market funds hold many foreign assets—they are a principal source of dollar funding for European banks—it would not be difficult to argue that stopping the runs on the money funds would help to stabilize the dollar. Moreover, Paulson’s plan likely would not involve actual spending or lending. If the backstop restored investor confidence, then the run should stop without any money leaving the stabilization fund. Indeed, because money market funds were charged a premium for the insurance, the Treasury would earn a profit from the program.

We continued to discuss what we should request from Congress. By now, everyone agreed that the crisis had become too big for the Fed and Treasury to handle without money appropriated by Congress. But, assuming Congress agreed, what was the best way to deploy the funds? Historically, governments have often ended banking crises by injecting capital into (that is, buying stock in) viable firms, so-called good banks. In some cases, troubled firms were made into good banks by separating their bad assets into newly incorporated vehicles—bad banks. The bad banks would be separately financed and, over time, would sell off their low-quality loans. I was inclined toward that approach, including having the government invest directly in banks in exchange for newly created stock. It seemed the simplest and most direct way to restore the banking system to solvency, to provide reassurance to investors and the public, and to support the flow of credit to households and businesses.

The economic logic of putting public capital into financial institutions aside, Hank had serious reservations. He feared that partial government ownership of banks would look socialistic, or like more bailouts, and thus would prove a political nonstarter. He believed, in particular, that House Republicans would never accept a plan that looked like a government takeover of banks. Going to Congress with a proposal only to have it turned down would devastate market confidence. He also worried that proposing government capital injections would panic existing bank shareholders. They would fear having their

ownership stake diluted, or even expropriated if public capital injections became the first step toward nationalization—the complete takeover of banks by the government. Our tough treatment of the shareholders of Fannie, Freddie, and AIG would offer little comfort to bank shareholders facing what they might see as the prelude to a government takeover. If existing shareholders took fright and sold their stock, bank share prices would slide, closing off any possibility of raising new capital from the private sector. Finally, Hank was concerned (as we all were) that banks that were partially or fully nationalized might find it difficult to reestablish profitability and return to private status.

Paulson proposed instead to use appropriated funds to buy bad assets from banks—effectively, a good bank–bad bank strategy for the whole system. He believed that government purchases of bad assets would not only take those assets out of the system but also put a floor under the prices of similar assets remaining on banks’ books. That floor would strengthen banks and help them raise capital more easily from private investors. His idea had its origins in a Treasury staff memo entitled “‘Break the Glass’ Bank Recapitalization Plan.” Quietly circulated in April, the memo discussed several strategies for bank stabilization but focused on buying $500 billion of mortgage-backed securities from financial institutions via auctions. Professional asset managers would be hired to manage the purchased securities and eventually resell them to private investors, with the goal of getting the best possible return for the taxpayers.

The break-the-glass memo was a useful exercise but it lacked detail, particularly on how the government would decide which assets to buy and how much to pay. After the memo’s circulation, Federal Reserve economists considered various types of asset-buying programs in more depth. They were concerned that asset buying would be complicated and might take a long time to develop and implement. They also were unable to find an exact precedent in earlier financial crises that could serve as a model. During the Swedish banking crisis of the 1990s, often cited as an example of a successful policy response, the government had purchased bad assets but only in conjunction with government injections of new capital into banks.

Nevertheless, I understood why Hank preferred this approach; and I believed that, since Hank would be the one persuading Congress to act, his views deserved some deference. If I had learned one thing in Washington, it was that no economic program can succeed, no matter how impeccable the arguments supporting it, if it is not politically feasible. Moreover, if the asset purchases raised the prices of troubled assets, as I believed they could, the system would be recapitalized indirectly. Most importantly, Hank assured me that the authority to purchase assets would be written broadly enough to allow the government to purchase equity shares in banks—that is, to inject government capital, my preferred approach—if that turned out to be best.

WE HAD A PLAN; the next step was to sell it. At 3:30 p.m., Paulson, Cox, and I met again with the president in the Roosevelt Room at the White House, together with staff from the White House and other agencies.

Kevin Warsh joined me. Once everyone was gathered, the president entered from the Oval Office and sat at his usual spot in the middle of one side of the long table. The participants had already found their places as indicated by printed name cards. I am pretty sure the president knew everyone and could have dispensed with the name cards, but protocol is powerful. As had become usual, Paulson, Cox, and I sat directly across from the president.

Hank and I updated him on market developments, including the runs on the money market funds. We emphasized the urgent need to control the crisis before the economy suffered more damage. At Hank’s request, I repeated my judgment that the Fed was nearing the end of its resources to stop the run on the financial system and that a comprehensive attack on the crisis using funds authorized by Congress was probably the only workable approach. We then reviewed the Treasury and Fed proposals to restore confidence in the money funds and Chris Cox’s proposed ban of short-selling. Finally, and most importantly, we turned to Hank’s proposal to ask Congress for money to buy bad assets.

For the second time in three days, we had come to President Bush to request his support for radical and unprecedented intervention in the American financial system. As a Republican with a strong predilection for letting the markets sort things out, the president couldn’t have been happy with the options we offered. He knew that it would be difficult to get his own party’s support. But, in the spirit of the approach that Franklin Roosevelt had taken three-quarters of a century earlier, he agreed that preserving the free market in the long run might require drastic government intervention in the short run. Once again, the president expressed his full support for us. We were grateful. Once again, Congress would be our next stop.

After I returned to my office, I called Speaker Pelosi and asked if Hank, Chris Cox, and I could meet with congressional leaders that evening. She said she would try to arrange it. At 6:00 p.m. Senator Obama called. I explained our strategy. He promised to be as supportive as possible. With the election little more than six weeks away, what happened in the financial markets and in the Congress could be important wild cards in what appeared to be a close contest. For the Fed, the situation was tricky: We needed to work closely with the administration and push for a legislative solution without appearing to be partisan.

Every Thursday afternoon the Fed reports on its balance sheet. Once a boring, under-the-radar release, it had become newsworthy for the information it provided on our lending. This Thursday, the report reflected deepening stress in the financial system. Lending to securities brokers through the Primary Dealer Credit Facility had reached a record $60 billion, up from zero the previous week. (A week later, PDCF borrowing would total $106 billion.) Meanwhile, borrowing by banks through the discount window rose by $10 billion from the previous week, to $33.5 billion. Over the next week, discount window loans would rise to nearly $40 billion, not far below the $45.5 billion borrowed the day after 9/11.

A FEW MINUTES BEFORE 7:00 p.m., Paulson, Cox, and I arrived at Room H-230 in the Capitol, a small

conference room near Speaker Pelosi’s office. The sun was beginning to set on the Mall as we took our places at a wooden conference table. Pelosi, Senate majority leader Harry Reid, and House minority leader John Boehner sat across from us. Other members, including the top-ranking members of the Senate Banking Committee and the House Financial Services Committee (roughly a dozen overall), were seated around the table. Paulson said a few words, then asked me to elaborate on the risks we faced.

I had no prepared remarks. With no notes, I don’t remember everything I said, although attendees later repeated much of it to the press. I wanted to convey the absolute necessity of quick action. I said that we risked a global financial meltdown, and that it might occur in days rather than weeks. I fully believed every word I said and I think the members could see that. The room was very quiet.

I then turned to the economic implications of a financial meltdown—for the country and their own constituents. Here, I tried for a balanced, even cautious, view. I didn’t want to be accused of hyperbole or of sparking panic. Although I drew an analogy to the Great Depression, when the unemployment rate had peaked at 25 percent, I also talked about the less severe but still very deep economic declines that had followed financial crises in Japan and Sweden. Based on those experiences, I said, if action was not taken immediately, we could expect a sharp recession and significant further declines in the stock market and other asset prices. Unemployment could rise from the current 6 percent to 8 or 9 percent, I said, with large nonfinancial companies like General Motors joining financial companies in bankruptcy.

I think it is fair to say that I made an impression. It’s probably also fair to say that, as dire as my warnings were, I underestimated the potential damage. No global financial crisis this large had been seen at least since the Depression, if ever. We had little basis for assessing the magnitude of its fallout. But my academic research and reading of history convinced me that the effects could be large, even catastrophic. As I spoke, I remember feeling quite calm. The only way forward, I believed, was to be as focused, deliberate, and methodical as possible. We needed to gain and keep legislators’ confidence that we had a plan that would work.

The legislators asked many questions. How much money would be needed? How would it be used? Would aid to financial companies come with requirements to lend and restrictions on executive pay? How would we help homeowners and other innocent bystanders hurt by the crisis? When would the administration propose legislation? We answered as best we could. Paulson mentioned the idea of using the appropriated funds to buy bad assets from banks but did not provide detail. When the meeting ended at close to 9:00 p.m., I snuck out without being snagged by reporters. My escape was made easier by the fact that the congressional leaders were perfectly happy to talk.

Despite all the bad news, I left the meeting feeling encouraged. I told Michelle Smith that I saw a developing consensus for action. The markets also were encouraged: The Dow Jones industrial average ended the day up 410 points as rumors about a possible comprehensive response to the crisis circulated.

ON FRIDAY, SEPTEMBER 19, the Board met at 7:30 a.m. I had already explained that the Treasury intended to

use the Exchange Stabilization Fund to guarantee the money market funds. But we believed our program to encourage banks to buy asset-backed commercial paper from money funds could also help stop the run, and we approved it. The money funds could use the cash received to meet withdrawals without having to sell their commercial paper or other assets into a falling market. Once again, we were fulfilling our fundamental role as a central bank by lending in the face of financial panic, albeit indirectly in this case. Because some of the largest funds were headquartered in Boston, we asked the Federal Reserve Bank of Boston, headed by Eric Rosengren, to run the program.

In the meantime, the central banks of Sweden, Norway, Denmark, and Australia were asking for currency swap lines. The FOMC had delegated the authority to initiate swaps to a committee consisting of Don, Tim, and me. We approved the requests and informed FOMC members. We left negotiation of the details to Bill Dudley and his team. Bill was also busy monitoring markets, helping to oversee various lending programs, and conducting the Fed’s market operations to maintain the federal funds rate near the FOMC’s 2 percent target. I commented to Don that Bill “must be a one-armed paperhanger up there.” In truth, we all felt like that paperhanger. As science fiction writer Ray Cummings once said, “Time is what keeps everything from happening at once.” During the past month, it had felt like time was not doing its job.

Later that morning, Paulson, Cox, and I stood next to President Bush in the Rose Garden as he defended the rescues of Fannie, Freddie, and AIG. He also cited the Fed’s injections of “much-needed liquidity into our financial system” through our lending and in coordination with other central banks. “These were targeted measures designed primarily to stop the problems of individual firms from

spreading even more broadly,” he said. “But these measures have not been enough, because they have not addressed the root cause behind much of the instability in our markets—the mortgage assets that have lost value during the housing decline and are now restricting the flow of credit.” He then described the initiatives we had discussed in the Roosevelt Room the previous day.

Markets liked what they heard. Short-term Treasury yields, which had plunged to a post–World War II low, rose very sharply. The three-month yield went from 0.07 percent to 0.92 percent between late Thursday and late Friday. This was good news. Traders were willing to sell ultrasafe Treasury bills in favor of other assets. At the same time, corporate funding costs dropped significantly, and outflows from money market funds slowed. The stock market rose more than 3 percent, bringing the Dow back to less than 1 percent below its closing level a week earlier, just before Lehman weekend. Stocks of financial companies, which were expected to benefit from the ban on short-selling, rose about 11 percent. We had also announced that the New York Fed would support the housing market by purchasing the short-term debt of Fannie and Freddie, which they issued to finance their purchases of mortgages. We bought $8 billion on Friday, helping to push down interest rates on those securities by a significant 0.6 percent. The broadly positive reaction reflected relief that at last we had a comprehensive plan to fight the crisis, whatever its specific elements might be.

I spent the rest of the day explaining the proposals the president had outlined to reporters, fellow central bankers, and Congress. It was difficult to read legislators’ reactions, but already I could tell that it was not going to be easy to enlist them in what they would undoubtedly perceive as a massive taxpayer bailout of Wall Street rather than as a critical step for stabilizing the economy.

I also met with a few staff and Board members to further think through design issues for Paulson’s proposal to purchase bad assets. Treasury had offered few specifics, and we wanted to understand the trade-offs of different approaches. The best historical analogy we could find was the Resolution Trust Corporation (RTC), which had successfully liquidated the assets of failed savings and loans following the S&L crisis of the 1980s. But the RTC differed from Paulson’s plan in a crucial way. Assets came to the RTC automatically when a savings and loan failed. It did not have to figure out how much to pay for those assets. In contrast, Paulson planned to buy troubled assets from solvent financial institutions—but at what price?

That question would prove to be the biggest roadblock to asset purchases. Should the government pay the current market price, or something else? If the government paid the current, depressed market prices (assuming that market prices could even be determined in such a dysfunctional environment), the program might do very little to restore bank solvency. Perversely, all financial institutions might be forced to mark down their assets to the government prices, which would worsen their financial condition, at least in terms of the official accounting measures. Alternatively, the government could pay a higher-than-market price—say, the estimated price that might prevail under more normal market conditions. As a patient investor, the government could wait for values to better reflect the assets’ longer-term returns. That would certainly help the banks, but would it be fair to the taxpayer if the government had to pay prices above those of the current market with the possibility of taking a loss when it came time to sell the assets? In the coming weeks, the Fed and Treasury would exhaustively analyze how to conduct auctions and value assets, but how best to set purchase prices remained a key question.

The urgency to act on so many fronts, together with the complexity of the problems we faced, exhausted all of us. That week, many senior staff worked through the night. We knew the choices we were making were vitally important. As Brad DeLong, an economics professor at the University of California, Berkeley, put it in his blog: “Bernanke and Paulson are both focused like laser beams on not making the same mistakes as were made in 1929. . . . They want to make their own, original, mistakes.”

ON FRIDAY EVENING, I heard through Fed supervisors that Goldman Sachs wanted to change its legal status, from a securities holding company to a bank holding company. As the name suggests, a bank holding company is a company that owns one or more banks. Goldman owned a small deposit-taking institution based in Utah, a so-called industrial loan company. The industrial loan company could quickly be converted to a bank, thus meeting the minimum requirement for Goldman to be a bank holding company. This change in legal status would have only one effect of consequence: Goldman would now be

supervised by the Fed instead of the SEC. Goldman’s executives believed that they could reduce the risk of a run on their short-term funding simply by announcing that the Fed would oversee their activities. Their motivation was incorrectly reported at the time as a move to secure access to Fed lending, but Goldman’s broker-dealer subsidiary already had access to Fed lending through the PDCF.

On Sunday, the Board approved Goldman’s application, and a similar application by Morgan Stanley, which had become very concerned about the stability of its funding. We allowed the changes in status to take effect immediately. At the same meeting, the Board permitted the London-based broker-dealer subsidiaries of Goldman, Morgan Stanley, and Merrill Lynch to borrow at the PDCF. Their New York offices already could borrow from the PDCF. Our action allowed the companies to use collateral held in London without transferring it to New York. These steps eased funding strains for both Goldman and Morgan. I saw that as evidence that, at least for these two companies, the crisis had aspects of a self-fulfilling panic—investors refusing to lend and counterparties refusing to transact only because they feared others would do the same. The conversions of Goldman and Morgan Stanley to bank holding companies—together with the failure of Lehman and the acquisitions of Bear Stearns and Merrill Lynch— brought the era of freestanding investment banks to a sudden conclusion.

Goldman and Morgan Stanley did not count on their new status as bank holding companies to secure their stability. Both companies also pursued new strategic investors. A week later, Goldman announced a $5 billion investment by Warren Buffett.

A man of wit and—despite his immense wealth—personal modesty, the Sage of Omaha had a connection to Washington that I hadn’t realized. His father served in Congress, so young Warren started some of his first businesses in Washington. According to Buffett, as a boy he organized several paper routes into a single business, making the other delivery boys his first employees. He told me that the Christmas cards he sent his customers each December read: “Merry Christmas. Third notice!” Buffett supported the Fed throughout the crisis and thereafter, boosting both the Fed’s political standing and my morale. I like to think that Warren’s consistent backing reflected his personal regard, but it could not have been lost on him that his support for beleaguered policymakers, by improving market sentiment, was good for the economy and, consequently, for his own investments. Certainly, by investing in Goldman at that particular moment, Buffett cast a critical vote of confidence in the U.S. economy, considerably reducing the stress on Goldman (and, indirectly, Morgan Stanley). His investment, on highly favorable terms, also paid off quite well for his shareholders.

As for Morgan Stanley, the deal they had been discussing with the Chinese did not work out. But in mid-October, Mitsubishi UFJ, Japan’s largest financial group, announced it would invest $9 billion. Before signing the papers, the financial group asked for and received assurances from Secretary Paulson that the U.S. government would not subsequently expropriate the Japanese stake in Morgan Stanley. With that investment in Morgan, and Buffett’s in Goldman, the two newly minted bank holding companies would be much less of a concern for us (and for the markets).

As the Sunday Board meeting suggests, weekends no longer had much meaning at the Fed (or the Treasury). I had tickets for a Nationals game on Sunday afternoon but instead found myself at a meeting, along with Hank, in Senator Bob Corker’s office with six Republican senators. We explained the Treasury’s proposal and possible alternatives. The discussion had useful moments, but Senator Bunning, who seemed constantly angry and was always angriest with the Fed, delivered a diatribe and walked out. The thrust of it was that the Fed could not be trusted to fix a crisis that, in his view, it had created through excessively easy monetary policy and poor regulation.

ON FRIDAY EVENING, the Treasury had sent congressional leaders a three-page synopsis of its proposed legislation. Paulson asked for $700 billion to purchase troubled assets. The figure was fairly arbitrary. It was an enormous sum, but (as Paulson pointed out) it was small in comparison to the roughly $11 trillion in outstanding residential mortgages, not to mention other real-estate-related assets such as commercial real estate and construction loans. The problem was gigantic, and the response would have to be proportionate. On the other hand, the $700 billion would not be government spending in the usual sense but rather the acquisition of financial assets. If all went well, the government would eventually sell the assets and recoup most or all of the money.

Lawmakers reacted with consternation to the Treasury’s proposal. In his own account, Paulson says he intended the three pages as an outline for discussion and assumed that Congress would fill in the details. However, many in Congress took the short proposal, written in the form of draft legislation, as a demand for essentially unlimited powers without oversight. This would not fly, although it was not Hank’s expectation in the first place. The proposal, dubbed TARP (for Troubled Asset Relief Program), was off to a bad start.

CHAPTER 15

“Fifty Percent Hell No”

On Tuesday, September 23, four days after Hank Paulson and I stood with the president in the Rose Garden, Hank and I were once again side by side. Across from us sat the visibly angry members of the Senate Banking Committee. They greeted the proposal for TARP with deep skepticism. How was the $700 billion program supposed to work? Would ordinary Americans see any benefit?

Under the camera lights and the stern glare of committee members, I did something that I had never done before and would never do again at a congressional hearing: I spoke extemporaneously from rough notes that I had jotted down just that morning rather than from a prepared text. I had agreed to support asset purchases, and I believed I was the right person to explain how they could strengthen financial institutions and stabilize the financial system while also treating taxpayers fairly. The economics professor in me took over.

“Let me start with a question,” I said. “Why are financial markets not working? Financial institutions and others hold billions in complex securities, including many that are mortgage-related. I would like to ask you for a moment to think of these securities as having two different prices. The first of these is the fire-sale price. That is the price a security would fetch today if sold quickly into an illiquid market. The second price is the hold-to-maturity price. That is what the security would be worth eventually when the income from the security was received over time. Because of the complexity of these securities and the serious uncertainties about the economy and the housing market, there is no active market for many of these securities. And, thus, today the fire-sale price may be much less than the hold-to-maturity price.”

Date: 2016-04-22; view: 628