Federal Reserve documents 23 page

Asset purchases could help, I continued, if the government paid prices somewhere between the fire-sale and hold-to-maturity prices—that is, prices that were low but nevertheless closer to what sellers

could obtain in a properly functioning market. Financial institutions could sell assets at the intermediate prices, and value the assets still on their books at those prices, without taking losses that threatened to exhaust their remaining capital. At the same time, prices lower than long-run, hold-to-maturity values would ensure that the taxpayers got their money back if, as we anticipated, the program helped restart the economy and the housing market.

The government would not have to calculate the fire-sale and hold-to-maturity prices of the assets, I argued. Prices between those two extremes would emerge automatically in auctions in which the government participated as a substantial buyer, perhaps along with buyers from the private sector. As evidence that this could work, I observed that the very announcement of the asset-purchase proposal had caused the prices of subprime mortgage assets to jump.

I believed then, and still do, that this way of thinking about asset purchases made the most sense. Sheila Bair also supported the idea. Of course, setting up fair and effective auctions for highly complex, difficult-to-value securities posed significant conceptual and operational problems.

For nearly five hours, the senators pressed us, raising questions and making suggestions of their own. Jack Reed, a financially savvy Democrat from Rhode Island, said taxpayers should share the profits if purchasing assets pushed up financial institution stock prices. In the middle of the hearing, Chris Dodd, the chairman of the committee, briefly noted a point that Hank hadn’t—that nothing in the bill prohibited the government from acquiring equity stakes in institutions. Reed’s and Dodd’s comments suggested they weren’t necessarily averse to partial public ownership of banks, although they seemed to think of it as a way to improve the returns to taxpayers rather than as a means of forcing restructuring or giving the government control over banks. In response, I encouraged the senators to give the administration broad flexibility in how it could use the $700 billion, depending on changing conditions and the outcomes of different approaches.

Senators repeatedly sounded the theme of fairness to Main Street. Mike Enzi, Republican from Wyoming, asked about small banks that did not have bad assets to sell to the government. Wouldn’t we be rewarding failure by buying assets from the mostly larger financial institutions who made many of the worst loans? Actually, many small banks did hold bad assets, but in pointing out that deeply troubled banks would benefit most from the program, Enzi was highlighting yet another instance of the conflict between doing what was necessary to save the system and avoiding moral hazard. Several senators said executive pay at any financial institution benefiting from the program should be restricted. Others, including Dodd, pushed for doling out the money in tranches rather than all at once, thereby allowing Congress to stop the program if it was not satisfied with the results. It was a long and difficult hearing, but I thought we had made progress.

The next day, Wednesday September 24, felt like cruel and unusual punishment. I faced two more grueling hearings—one before the Joint Economic Committee and another before Barney Frank’s House Financial Services Committee—as well as contentious meetings with the House Republican Conference

—essentially, all the Republican members of the House—and the Senate Democratic Caucus. The morning before, House Republicans had angrily rebuffed an appeal from a delegation that included Vice President Cheney, White House Chief of Staff Josh Bolten, Keith Hennessey of the National Economic Council, and Kevin Warsh from the Fed.

Hank and I did our best with the House Republicans, but we had no better luck than the vice president’s delegation. Lawmakers lined up behind microphones on each side of the large caucus room to vent. Their message: Bailing out Wall Street fat cats would be a gross injustice, a gift from Main Street to Wall Street. One member told us that he had spoken to small-town bankers, auto dealers, and others in his district with knowledge of the “real” U.S. economy. So far, he said, they had not seen any meaningful effects of the Wall Street troubles. “They will,” I said to him. “They will.” Developments on Wall Street, remote as they might seem, had the potential to choke off credit to small businesses and entrepreneurs and cripple the economy, I said. But most of the legislators were skeptical. I worried that Congress would act decisively only when the economic damage was apparent, large, and in all likelihood irreversible.

Throughout the day I hammered home the argument that deteriorating credit conditions posed a grave threat. “Credit is the lifeblood of the economy,” I told the House Financial Services Committee. If the financial conditions didn’t improve, “we’re going to see higher unemployment, fewer jobs, slower growth, more foreclosures. . . . This is going to have real effects on people at the lunch-bucket level.”

The perception that the financial crisis was not Main Street’s concern was not our only problem: The asset-purchase plan remained difficult to explain and controversial for several other reasons. Some outside economists said that it would either not help (if assets were purchased at low prices) or would be unfair to taxpayers (if the prices were high). That criticism ignored my argument that auctions would produce prices between low fire-sale prices and higher hold-to-maturity prices. Others saw problems in designing auctions, because of the complexity and diversity of the securities to be purchased. I thought that objection, though legitimate, could be answered as well. But, despite our best efforts to make the case for asset purchases, I saw little evidence of an emerging consensus in favor of them and widespread confusion about how they would work.

Even as I explained asset purchases, I tried to preserve the administration’s flexibility. I thought an oversight board could be empowered to make changes as needed. I didn’t know how the crisis would evolve, so to a certain extent I was trying to have it both ways: supporting Hank’s strategy, while trying to retain an option for direct government capital injection or other approaches.

When Hank and I met with Democratic senators in the Capitol, they seemed no more inclined toward the Treasury plan than Republicans. The main difference, not surprisingly, was that Republicans wanted the government to do less (stand aside and let the system adjust on its own) and Democrats wanted the government to do more (act directly to help Main Street and to reduce executive compensation).

After the last meeting, exhausted and dispirited, I went home. Anna and I watched President Bush on TV, addressing the country. His plea for decisive action to end the crisis was effective, I thought. But by

this point, on this issue, I was not an objective observer.

THURSDAY MORNING, September 25, market conditions were improving a bit. The Treasury and Fed programs to stabilize the money market funds appeared to be working. Outflows from prime funds had largely ceased. The commercial paper market also seemed to be functioning better. Still, both financial and nonfinancial companies continued to face challenges obtaining funding.

Meanwhile, the president had given Paulson a free hand to negotiate with Congress, and Hank began hectic rounds of shuttle diplomacy. The independent and nonpartisan Fed had no standing to be actively involved in political deal making. So we watched developments carefully and stood ready to respond to questions and make suggestions. I took calls from legislators. Most were looking for a politically acceptable way to do what had to be done.

The key questions at this point, it seemed to me, were how best to structure asset purchases, if any, and whether we should instead shift our focus to capital injections or something else. But as the debate grew ever more contentious, most legislators seemed unwilling or unable to grapple with the core issues. Instead, Hank found himself negotiating a range of auxiliary issues: restrictions on executive compensation, disbursing TARP money in tranches, helping troubled mortgage borrowers (very important but unlikely to end the crisis in time to avoid a meltdown), details of program oversight, and the treatment of small banks.

The fight over compensation illustrated the tensions between political and economic imperatives. Many in Congress wanted to cap pay at financial institutions that benefited from taxpayer dollars. The political appeal was clear, and, once again, I certainly understood why people were angry. Even before the crisis, many people saw financial executives’ big paychecks as unfair. Now, with financiers’ excessive risk taking having helped drive the economy into a ditch, the unfairness was stark. But, as a practical matter, if the conditions for participation in TARP were too onerous, firms would do what they could to stay away. We could not force a bank to take capital. If strong banks avoided the program, then weaker banks would not want to participate, either, since doing so would mark them as weak in the eyes of customers and creditors. That dynamic would doom our efforts to failure. Moreover, the proposed restrictions on executive compensation made no distinction between the executives running financial companies when they foundered and their successors trying to clean up the mess. We needed skilled and experienced professionals to come in and quickly restructure troubled firms. There weren’t many like Ed Liddy, who had agreed to run AIG for a dollar a year.

In worrying about the practical aspects of the plan more than political considerations, I may have been tone-deaf. But most of my colleagues on the front lines, including Hank and Tim, seemed to share my perspective. Tim, in particular, complained about the “Old Testament” attitude of politicians who seemed more interested in inflicting punishment than in avoiding impending disaster. We were fine with bad actors getting their just deserts, but we believed it was better to postpone the verdict on blame and guilt

until the fire was out. I had also over the years seen a great deal of feigned outrage in Washington, and I didn’t feel like playing that game. I focused on solving the problems we faced and avoided sweeping populist indictments of bankers, in part because I knew that there was plenty of blame to go around, including at the Fed and other regulatory agencies and in Congress. Perhaps my low-key approach hurt us politically, but I was not comfortable proceeding in any other way.

The presidential election created further complications. In an ill-advised move, Republican Senator John McCain had suspended his campaign to come to Washington, supposedly to address the crisis. But the crisis was too large and complex for one senator to solve, even a nominee for president. We worried that one or both candidates would try to use the crisis for political advantage, complicating any potential deal in the Congress.

At McCain’s request, President Bush convened a meeting at the White House on Thursday evening. I decided not to go. I didn’t want to compromise the Fed’s political independence by getting involved in the details of legislative disputes. All the other key players did attend, including the president, Hank, both presidential candidates, and congressional leaders of both parties. They had a chance to strike a deal. Both candidates had broadly endorsed Hank’s plan, and the Senate Banking Committee had issued a set of bipartisan principles that included limits on executive compensation and giving the government equity stakes in companies receiving aid. President Bush tried to push the meeting toward an agreement, but it devolved into acrimony and disarray. Election politics and Republican resistance, especially in the House, prevented a deal. The Democrats, besides their substantive concerns, were miffed at having to provide most of the votes to pass an unpopular measure proposed by a Republican administration. McCain, despite having asked for the meeting, seemed unwilling to work actively for a solution.

One impediment was a proposal by Eric Cantor and several other House Republicans to replace asset purchases with an insurance program. For a fee, the government would insure assets against losses. I never understood the appeal. Cantor argued that his proposal would save taxpayers money, but he eventually conceded that it would not work for the most complex securities, which were the heart of the problem. Insuring those assets required setting a value for them as well as a fair premium. It was no simpler than asset purchases. Moreover, unlike purchases, insurance gave the taxpayer little upside if the assets appreciated. To gain a few additional Republican votes, the final bill included an optional version of Cantor’s plan that would never be deployed.

On the left, legislators and economists pushed for helping homeowners in trouble rather than purchasing assets. I had no doubt that avoiding unnecessary foreclosures would benefit both borrowers and the broader economy, and I had often said so. But developing a cost-effective program, without being unfair to borrowers who had faithfully paid their mortgages, would take considerable time. With the financial system perhaps only days or weeks from collapse, we needed rapid action.

While both campaigns were in contact with the Fed, Obama seemed more interested in my views than McCain was. Obama called me for updates and had visited my office in late July. He was already leading

in the polls at that point. I greeted him on his arrival at the Board garage and we rode up together in the small elevator, jammed in with security agents and staff. At our meeting we discussed recent developments but also steps he might take as president to reform financial regulation and strengthen the economy. I was pleased that he made a point of emphasizing his support for the Federal Reserve’s independence. (He also charmed Rita Proctor and other administrative staff who gathered near my door, speaking briefly to each.)

McCain, on the other hand, seemed to be grasping for the right political stance. I had a favorable impression of McCain, a straight talker and an effective senator. (And Anna and I enjoyed meeting his mother, Roberta, at the time nearly a hundred years old, at a performance of the impressive Marine Corps Silent Drill Platoon at the Marine Barracks on Capitol Hill.) Given his military background, McCain seemed more comfortable with foreign policy and military matters than with economics, but he was experienced and smart enough to know that, with the financial system near collapse, a laissez-faire approach wouldn’t work. But he was vulnerable, both because his Republican base detested any government action that looked like a bailout and because the crisis and the proposed response occurred during a Republican administration.

He certainly did not think through his decision to suspend his campaign to come to Washington. He arrived without clear buy-in on a plan from Republican congressional leaders. On the Saturday after the White House meeting he called me at home and asked a few questions, indicated his support for the administration’s proposal, and confessed his chagrin about any problems his intervention might have caused. He promised to “keep my head down.” At one point, he compared the recurring explosions in the financial sector to IEDs, the military’s acronym for improvised explosive devices.

The Board staff worked hard with senior staff from the Treasury and the New York Fed to design an effective asset-purchase program. I followed the work closely. At my urging, the staff also engaged outside experts on auction design. Despite these efforts, experienced members of my staff remained concerned about whether the government, as Hank hoped, could buy enough assets quickly enough to calm the crisis. “The problem . . . is a mismatch between rhetoric and reality,” David Wilcox wrote to me. “I am becoming more convinced by the week that the need for large-scale capital infusion is drawing nearer. I don’t think we’re there yet, but we’re getting closer.”

ON THURSDAY, THE day of the ill-fated White House meeting, Don Kohn relayed news from Sheila Bair: JPMorgan had made a bid for Washington Mutual. Sheila was pleased because JPMorgan’s acquisition involved no cost to the FDIC and no losses to uninsured depositors, such as corporations and municipalities. However, as a condition of the deal, not only WaMu’s shareholders but also the holders of the company’s senior debt—debt that was supposed to be paid first, before any other type of unsecured debt—would suffer significant losses.

I and others at the Fed, including Tim Geithner and Randy Krosz-ner, worried that forcing senior

debt–holders to take losses, while the right and usual thing to do in normal times, would be a mistake in our current circumstances. It would create even more uncertainty about how the government would treat failing firms and make it harder for other banks to issue new debt. Senior debt had been protected at Fannie and Freddie and AIG, for example. Tim, whose relationship with Sheila was strained at best, was particularly exercised about the decision, but the Fed had limited leverage on this issue. The deal was negotiated largely between the FDIC and JPMorgan. JPMorgan indicated the deal was off if it had to make good on WaMu’s senior debt, and Sheila adamantly opposed allowing the deposit insurance fund to incur any costs to protect senior debt–holders. (Sheila was tenacious about protecting the deposit insurance fund, which was admirable; but sometimes it seemed that she put the fund ahead of the interests of the broader financial system.) As justification for her position, Sheila could point out that the Federal Deposit Insurance Corporation Improvement Act of 1991, FDICIA for short, required the FDIC to resolve failing firms at the lowest possible cost to the deposit insurance fund. The requirement could be suspended only if the FDIC, the Fed, and the Treasury all agreed that doing so endangered the stability of the entire financial system. This “systemic risk exception” had never before been invoked.

The Office of Thrift Supervision bowed to the inevitable and shut down WaMu, allowing it to default on its senior debt and other liabilities. The FDIC seized the company’s assets and assured depositors they would be protected. JPMorgan completed the transaction overnight, paying the FDIC $1.9 billion for WaMu’s banking operations and loan portfolio. It was the largest bank failure in U.S. history. To strengthen its own position, JPMorgan raised $11.5 billion in additional capital by issuing new common stock. That Jamie Dimon’s bank could raise capital in this environment was itself a show of strength.

Whether the FDIC’s decision to impose losses on WaMu’s senior debt–holders worsened the crisis is controversial. Sheila has strongly defended the action. She told the Senate in April 2010 that the resolution went smoothly. And in another forum that year she said, “It was below the fold if it was even on the front page . . . barely a blip given everything else that was going on.”

My view, shared by others at the Board like Randy Kroszner, was that the WaMu decision, while perhaps not catastrophic, probably did hasten the fall of the next financial domino—Wachovia. By this time, Wachovia was headed by Bob Steel, a Goldman alum who, having served for twenty-one months as Paulson’s undersecretary for domestic finance at the Treasury, had replaced ousted Wachovia CEO Ken Thompson in July 2008. Wachovia’s fundamental problem was a large portfolio of low-quality mortgages. After WaMu’s senior debt–holders suffered losses, unsecured creditors started to run from Wachovia and other struggling banks. By noon on the day after the WaMu failure, creditors were refusing to roll over Wachovia’s short-term funding, including commercial paper and repo.

On Friday morning, September 26, I saw Paulson for breakfast at the Treasury. Hank told me he was becoming optimistic about getting a deal on TARP. Importantly, he also seemed more open to the idea of the government’s injecting capital into financial institutions, either by “co-investing” with the private sector or through some type of auction. When I got back to my office I immediately emailed Geithner,

Kohn, Kroszner, and senior staff including Wilcox. “He has been very resistant” to capital injection, I wrote. “Today he switched gears and said he thought those were fine ideas.” However, Hank said he would not change his legislative strategy. He would continue to emphasize asset purchases in public discussion while simultaneously pressing for maximum flexibility in the use of TARP funds. I nevertheless encouraged Fed staff members to redouble their efforts to determine how best to structure public capital injections. “Very good chance they will actually be relevant,” I wrote.

Scott Alvarez, Brian Madigan, and our legislative team were tracking another provision in the TARP bill that would give us the ability to control short-term interest rates even as our interventions, such as our swaps with foreign central banks, caused our balance sheet to grow. In 2006, Congress had granted the Fed the authority to pay banks interest on the reserves that they hold at the Fed. However, for budgetary reasons, the authority had been set to become effective five years later, in 2011. But we asked, as part of the TARP legislation, that we be allowed to pay interest on reserves immediately.

We had initially asked to pay interest on reserves for technical reasons. But in 2008, we needed the authority to solve an increasingly serious problem: the risk that our emergency lending, which had the side effect of increasing bank reserves, would lead short-term interest rates to fall below our federal funds target and thereby cause us to lose control of monetary policy. When banks have lots of reserves, they have less need to borrow from each other, which pushes down the interest rate on that borrowing—the federal funds rate.

Until this point we had been selling Treasury securities we owned to offset the effect of our lending on reserves (the process called sterilization). But as our lending increased, that stopgap response would at some point no longer be possible because we would run out of Treasuries to sell. At that point, without legislative action, we would be forced to either limit the size of our interventions, which could lead to further loss of confidence in the financial system, or lose the ability to control the federal funds rate, the main instrument of monetary policy. The ability to pay interest on reserves (an authority that other major central banks already had), would help solve this problem. Banks would have no incentive to lend to each other at an interest rate much below the rate they could earn, risk-free, on their reserves at the Fed. So, by setting the interest rate we paid on reserves high enough, we could prevent the federal funds rate from falling too low, no matter how much lending we did.

AFTER BREAKFAST WITH Hank, I called Mervyn King and Jean-Claude Trichet to broach the idea of a joint interest rate cut. To my knowledge, major central banks had never coordinated interest rate cuts, and I thought that joint action would send a powerful signal of international unity. Mervyn, who after his early reticence to intervene had become a supporter of aggressive action, was somewhat more open to my idea than Jean-Claude. Both promised to think about it. I told Don and Tim that a joint rate cut looked possible but some further persuasion might be needed, especially for the ECB. Don replied that he would discuss the issue with the second-in-commands at the two central banks and suggested bringing the Canadians and

the Japanese into the negotiation.

The United States was not alone in suffering from fragile financial institutions and markets. Since the run on Northern Rock the previous September, both the British and the continental Europeans had been putting out large financial fires. We learned on Friday that the giant Belgian-Dutch financial firm Fortis, a 775-billion-euro company that combined banking and insurance, was in dire straits, the result of investments in collateralized debt obligations and a mismanaged takeover of parts of the Dutch bank ABN AMRO. On Saturday, Don Kohn reported on a call from ECB vice president Lucas Papademos. “Fortis is a mess,” was Don’s summary. Papademos told Don that ING, a multinational firm headquartered in Amsterdam, and BNP Paribas, the French bank whose August 2007 announcement blocking withdrawals from its subprime mortgage funds had helped set off the financial crisis, were bidding for Fortis. But, he told Don, the deal probably wouldn’t get done over the weekend, and the ECB was worried about how the markets would react.

The Europeans acted more promptly than Papademos had expected. On Sunday, the governments of Belgium, the Netherlands, and Luxembourg collectively injected more than 11.2 billion euros ($16 billion) of capital into Fortis. The ECB also lent dollars to Fortis, drawing on the swap line with the Fed. In an even bigger intervention, Germany’s second-largest commercial property lender, Hypo Real Estate, received government and private guarantees totaling about 35 billion euros ($50 billion). Other problem institutions included the British lender Bradford & Bingley (partially nationalized at the end of September, using procedures developed for Northern Rock) and the German-Irish bank Depfa (a Hypo Real Estate subsidiary that was nationalized by the German government). The Belgian bank Dexia, which had made a large loan to Depfa, would be bailed out on September 29.

BACK IN THE United States, Wachovia was deteriorating even more quickly than we had anticipated. At the time the fourth-largest bank holding company in the United States, Wachovia was an even bigger financial bomb, potentially, than either Washington Mutual or Lehman. Its subsidiary banks had substantial uninsured liabilities, including unsecured debt, wholesale funding, and foreign deposits. Moreover, unlike WaMu, Wachovia conducted significant business activities outside its bank subsidiaries, in affiliated companies like its securities dealer or in the holding company itself (which had issued more than $50 billion in long-term debt).

Sheila Bair, who well understood the risks that Wachovia’s collapse would pose, wanted to find a buyer for the whole company: the parent company, the nonbank affiliates, and the bank subsidiaries. Kevin Warsh had been leading an effort to evaluate the possibility of a merger between Goldman Sachs and Wachovia. However, that option disappeared as Goldman grew nervous about the losses embedded in Wachovia’s balance sheet.

Citicorp and Wells Fargo also had expressed substantial interest. Merging Wachovia into another big bank wasn’t ideal. It would increase the overall concentration in the banking industry, already dominated

by the largest firms, and might also weaken the acquiring company. Still, given the circumstances and our rapidly shrinking options, it seemed the best solution. One consolation was that Citicorp and Wells Fargo had relatively little presence in the Southeast, where Wachovia was strongest. Consequently, a merger with either of the two wouldn’t weaken regional competition for deposits and lending.

Managing Wachovia consumed the weekend, culminating in another all-night negotiation from Sunday to Monday, September 28–29, involving the holding company, its potential acquirers, and three regulators —the FDIC, the Fed, and the Office of the Comptroller of the Currency (which regulated Wachovia’s largest bank). On Sunday morning, the prospects for a clean acquisition by either Citi (then the nation’s largest bank holding company, about two and a half times larger than Wachovia) or Wells (the sixth largest—about three-quarters of Wachovia’s size) looked good.

Citi’s new CEO, the mild-mannered, urbane Vikram Pandit, then fifty-one, was aggressively pursuing Wachovia. Pandit struck me as sharp and sensible, although a number of supervisors (especially those at the FDIC) had reservations about his qualifications to lead Citi. He had spent most of his career in securities trading, at Morgan Stanley, rather than in traditional commercial banking. He had taken the helm at Citi in December 2007 after Chuck Prince (of “we’re still dancing” fame) was pushed out. Pandit grew up in central India, came to the United States at sixteen, and earned degrees in electrical engineering before switching to business and completing a doctorate in finance at Columbia University. His mission at Citi was to refocus the ailing behemoth on its core strengths as a global commercial bank while ditching Citi’s bad assets and improving its risk management.

Date: 2016-04-22; view: 599