Federal Reserve documents 24 page

Pandit’s rival for Wachovia was the irascible and opinionated Dick Kovacevich, veteran chairman of Wells Fargo. Kovacevich had started his banking career at Citi and was CEO of the Minneapolis-based Norwest Corp. when it bought and assumed the name of San Francisco’s Wells Fargo in 1998. Kovacevich had skillfully managed the integration of the two companies’ operations and had avoided the riskiest subprime mortgages that had gotten many of its competitors into trouble. He had given up the CEO title the year before to his longtime number two, John Stumpf, and had been set to fully retire at the end of the year. But, a month short of his sixty-fifth birthday during the negotiations over Wachovia, he was looking for one more big deal.

After showing initial enthusiasm, though, Kovacevich decided on Sunday to back away, apparently out of concern over potential losses from Wachovia’s commercial loans. Whether Wells would return to the negotiations, and if so on what terms, was unclear. That left Citi as potentially the sole bidder.

Because Wachovia included a large bank subsidiary, the government possessed a tool that had not been available with Lehman. The FDIC could purchase or guarantee some of the bank’s assets, which could make the company as a whole more attractive. However, as in the case of WaMu, the law required the FDIC to resolve the bank at least cost to the deposit insurance fund, unless suspending the rule was necessary to avoid a substantial risk to the broader financial system. Doing so required the approval of two-thirds of the FDIC’s board, two-thirds of the Federal Reserve Board, and the Treasury secretary,

after consultation with the president.

Sheila had told me she thought a Wachovia deal could be done without government assistance, but, just in case, the Fed Board on Sunday afternoon approved a systemic risk exception, for the first time since enactment of the FDICIA law seventeen years earlier. We notified the FDIC. Meanwhile, Paulson got the president’s approval. Don and I persuaded Sheila that the system could not withstand the failure of another major firm, and that invoking the exception would provide important flexibility in the negotiations. Josh Bolten, the president’s chief of staff, called her Sunday evening to express White House support for invoking the exception. This time, Sheila accepted our arguments. The FDIC board acted early the next morning, completing the necessary approvals.

Sunday’s all-night vigil involved many calls and meetings with exhausted staff. Kovacevich had gone to ground at the Carlyle Hotel in New York City, where he was monitoring developments. Citi executives seemed more eager. They coveted Wachovia’s more than 3,300 bank branches and its nearly $420 billion in deposits, a reliable and low-cost source of funding. But Citi had problems of its own and wanted the FDIC to limit the losses it might inherit from Wachovia. Sheila asked the Fed and the Treasury to shoulder some of the risk. I was sympathetic and eager to get a deal done, but at the time I didn’t see a way for the Fed to help. With the TARP legislation not completed, the Treasury had no money, either. In the end, the FDIC agreed to guarantee any losses in Wachovia’s $312 billion loan portfolio beyond $42 billion. In return, the FDIC would receive preferred stock in Citi, as well as the option to buy additional stock and thereby benefit from any increase in Citi’s stock price.

With that, Citi agreed to acquire all of Wachovia’s liabilities—deposits and debt—as well as all of its loans. When Sheila’s staff assured her that the FDIC was unlikely to lose money on the acquisition, and that the official accounting for the transaction would reflect that conclusion, she signed off. As Hank Paulson would note in his memoir, while he was struggling to obtain $700 billion from Congress to help the entire financial system, the FDIC had agreed to guarantee $270 billion in loans for a single bank and nobody seemed to notice. In this case, I thought Sheila had done well balancing her responsibility to protect the deposit insurance fund with the need to avoid a systemic financial crisis. I congratulated her and her staff.

But the story wasn’t over. After the sale to Citi was announced on Monday but before it was final, Kovacevich and Wells Fargo came back with an offer for Wachovia that did not require loss protection by the FDIC. Wells Fargo’s reentry was motivated in part by an IRS notice issued on September 30, which increased the tax advantages that Wells expected if it completed the acquisition. Sheila much preferred the Wells offer, both because of the reduced risk to the FDIC and because she saw Wells as the stronger pair of hands. She encouraged new negotiations between Wachovia and Wells.

Once again the Fed and the FDIC were at odds. We thought Sheila’s desire to get a better deal for the FDIC fund had trumped other important considerations. Future negotiations could be jeopardized if the government refused to honor the agreement with Citi that it had helped to arrange. And we worried that

the demise of the existing deal would fan market fears about Citi, which already had trumpeted the acquisition as strengthening its franchise.

On Thursday evening, October 2, Don let me know that Sheila was pressing forward on the Wachovia-Wells merger. She was “completely unconcerned about integrity of auction process” or the market uncertainty about Citi that could result from revoking the earlier deal, Don said. That message was the prelude to yet another night of negotiation. Lawyers for Wachovia and Wells worked feverishly. Meanwhile, Citi was in the dark. Kevin Warsh emailed me just before midnight that Bob Steel (possibly with Sheila) would call Citi after Wachovia’s board had approved the deal with Wells. “Expect C to be outraged and to threaten legal action in the am . . . Our message: Wells took offer to Wachovia (no blessing from us) and FDIC gave them license,” Kevin wrote.

At 3:00 a.m. on Friday, October 3, Don Kohn emailed: “Sheila and Bob called Vikram. . . . Vikram went ‘nuts.’ Sheila defended the decision saying better deal for ‘the fund.’ Not pretty. . . . will make for tricky markets in the am.” Later, Vikram called me and vented bitterly. He urged us to block Wachovia’s deal with Wells. Like all bank holding company mergers, it required the approval of the Fed’s Board. He warned that Citi could be in danger if its own deal didn’t go through, because markets had come to believe Citi needed Wachovia’s deposits to survive. I also heard from Robert Rubin, the former Treasury secretary, now a senior counselor and board member at Citi. He thought that Citi might be able to improve its offer and get back in the game.

Tim weighed in strongly on Citi’s side. He acknowledged that Wells Fargo’s offer was superior but argued that allowing the deal to be scuttled at this point would destroy the government’s credibility as an honest broker. He warned that the United States would look like a banana republic if the government arbitrarily reneged. In contrast with the WaMu deal, the Fed’s authority over holding company mergers gave us some leverage. (Because WaMu was a savings institution, and JPMorgan’s bank, which acquired WaMu, was a nationally chartered bank regulated by the Office of the Comptroller of the Currency, Fed approval had not been required in that case.) However, the law requires specific findings for rejecting a merger of holding companies. We had to find, for instance, that a merger would hurt competition in local banking markets or that the banks involved had not met their responsibilities to invest in local communities. None of these criteria provided much basis for favoring Citi over Wells. The real issue, whether Wachovia’s acceptance of Wells’s offer had violated its provisional agreement with Citi, was a matter for the courts, not the Federal Reserve.

We worked for compromise. To help mollify Citi, we supported allowing it to increase its deposit base by acquiring Wachovia’s branches in several northeastern states. In exchange, Citi agreed not to try to block the merger of Wells and Wachovia, although it would continue to seek damages of $60 billion from Wells. The Fed Board approved the merger of Wachovia and Wells Fargo on October 9. I spent several hours assuring senators and representatives from North Carolina that the merger did not mean the end of the bank’s role as a major employer in Charlotte. To the contrary, I told them, avoiding the

collapse of Wachovia should help preserve local banking jobs as well as avoid much more serious economic consequences for the country.

AS REGULATORS TENDED to the Wachovia negotiations, Paulson had continued his discussions with congressional leaders about TARP. Early Monday morning, September 29, he called to report that they shook hands at 1:00 a.m. Hank’s experience as a Wall Street dealmaker had paid off. He had successfully resisted significant changes to the legislation. The money would be disbursed in two $350 billion tranches. Congress could prevent the second tranche from being used only by passing a bill and sustaining it over the president’s veto. If the program lost money after five years, the president would have to propose a plan for recovering the losses through fees on the financial services industry. There would be multiple oversight bodies, including a special inspector general and a congressional oversight panel, and also a board of cabinet-level officials (I would end up being the chair) that would advise on how best to use the funds.

The deal included Senator Jack Reed’s idea of using stock warrants (the right to purchase common stock at a fixed price) to give taxpayers a share of the gains if participating companies rebounded. It also required Treasury to develop a plan to help mortgage borrowers in trouble. The three-page plan that Treasury had sent to the Congress was now more than a hundred pages of legislation. The critical elements of the Treasury proposal—the authorization of funding and the flexibility to use the money as needed—were intact. The final bill also retained the provision moving up the effective date of the Fed’s authority to pay interest on bank reserves. After Paulson announced the deal, both presidential candidates guardedly lent their support.

Meanwhile, on an FOMC conference call Monday morning, I updated the Reserve Bank presidents on Wachovia developments, as well as the implications of our newfound interest-on-reserves authority. I also asked the Committee to more than double our currency swap lines with major foreign central banks to $620 billion, which it did. The crisis was hitting European banks even harder than those in the United States. On Monday alone, the stock price of Anglo Irish Bank plunged 46 percent, Dexia fell by 30 percent, Germany’s Commerzbank and Deutsche Postbank by 23 and 24 percent, respectively, and Sweden’s Swedbank by 19 percent. I could hardly imagine a clearer vote of no confidence.

But the most important event of September 29 would be the congressional vote on TARP. Americans wanted us to end the financial crisis, but we had failed to persuade them that pouring hundreds of billions of taxpayer dollars into the financial system was the solution. Senator Jon Kyl of Arizona told me that his constituent calls on TARP were running fifty-fifty: “fifty percent no, fifty percent hell no.” Editorialists and op-ed writers generally supported the legislation, though often with thumb and forefinger firmly pinching their nostrils. “The alternative to this admittedly imperfect and highly uncertain program could be much, much worse,” the Washington Post wrote.

I thought that the bill would pass, given that the leaders of both parties had signed off. But late

Monday morning, Kevin Warsh, who was monitoring Hill developments, sent a troubling email: “FYI. Last thing we need but there is a real House GOP problem in coming up with enough votes such that Speaker delivers on her side.” The syntax of the sentence, composed I’m sure in haste, was a little garbled, but the message was clear: Republican support was thin and Speaker Pelosi’s troops, who did not want Democrats to be seen as the party of TARP, were not willing to make up the difference.

Two hours after Kevin’s email, it was clear that the House would defeat the bill. House leaders kept the vote, originally scheduled for fifteen minutes, open for forty minutes, hoping to persuade “no” voters to switch. When the gavel banged at 2:10 p.m., the yeas were 205 and the nays, 228. I had watched the progress on the television in my office, together with the market reactions on my Bloomberg screen. I felt like I had been hit by a truck. So did the stock market. The Dow Jones industrial average plunged nearly 778 points—its worst-ever one-day decline in point terms, a record that still stands. In percentage terms, it was down 7 percent, the worst since the first trading day following the 9/11 attacks. Meanwhile, the S&P 500 fell by almost 9 percent. In all, $1.2 trillion in value vanished from the U.S. stock market in a single day.

The House vote seemed a crippling setback to our efforts to end the crisis. But constituent support for TARP increased significantly as people saw their 401(k) retirement accounts shrinking—or their “201(k) accounts,” as they were being called. Sobered congressional leaders regrouped and tried again. They sweetened the bill by including a temporary increase (later made permanent) in deposit insurance, from $100,000 to $250,000 per account. The Senate passed the bill, 74–25, on Wednesday, October 1, and the House, 263–171, on Friday, October 3. The president signed it that afternoon.

The administration had a powerful new weapon, and, finally, primary responsibility for restoring financial stability would no longer rest solely with the Fed.

CHAPTER 16

A Cold Wind

The bloodletting in financial markets continued during the week after the president signed the TARP legislation (known formally as the Emergency Economic Stabilization Act). Stock prices sometimes swung up and down by hundreds of points in an hour, driving indicators of market volatility to record levels, but always the prevailing trend was down. From Friday, October 3, to Friday, October 10, the Dow Jones industrial average lost 1,874 points, a shocking 18 percent. I tilted the Bloomberg screen in my office away from my desk so that I wouldn’t be distracted by the flashing red numbers.

Notwithstanding the enactment of TARP, confidence in financial institutions had nearly evaporated, and even strong nonfinancial companies found credit extremely difficult to obtain. The week before, General Electric, a top-rated conglomerate with both financial and nonfinancial arms, had been forced to raise $3 billion in capital from Warren Buffett before lenders would roll over its commercial paper. Interest rates on corporate bonds and the cost of insuring against corporate default shot skyward—a sign that traders were expecting the slumping economy to bring down more companies.

In public I described what was happening as the “worst financial crisis since the Great Depression,” but privately I thought that—given the number of major financial institutions that had failed or come close to failure, its broad-based effect on financial and credit markets, and its global scope—it was almost certainly the worst in human history. Whether the financial crisis would touch off the deepest economic downturn since the Depression, or something even worse, remained an open question. The data depicted an economy sinking ever further. The Fed’s regular survey of bank loan officers during the first half of October would show that banks were sharply tightening their lending terms and credit flows to families and businesses were drying up. Employers had shed 159,000 jobs in September—the ninth straight

monthly decline. Unemployment, still only mildly elevated at 6.1 percent, was clearly headed for a sharp rise.

The deepening slump was evident not only in government statistics but also in what we were hearing from business and community leaders around the country. In mid-October, Governor Betsy Duke went to San Francisco to meet with the Reserve Bank’s private-sector board and an advisory panel of businesspeople from around the region. “The comments are stunning and terrifying,” Betsy wrote me in an email. “Across the board every business reporting a complete ‘hunkering down.’ They are canceling every capital project and discretionary program possible. Credit is increasingly unavailable. . . . Small businesses and non-profits . . . are missing payrolls and shutting down. I would plead to do anything possible to restore confidence in the entire financial system.”

The economic effects of the crisis spread rapidly, without regard for national borders. In November, while in Sгo Paulo for an international meeting, I made time to meet with the CEOs of the largest Brazilian banks and other local business leaders. “In early September everything was fine,” one of the CEOs told me. “Then all of a sudden everything stopped. No borrowing, no investment. It was like a cold wind blew through the economy.”

FOR SEVERAL WEEKS, Hank Paulson and I had been debating the relative merits of purchasing troubled assets versus injecting capital into distressed banks. In our private conversations, Hank had moved toward my preferred strategy—capital injections, in which the government would acquire stock and thus partial ownership of banks. Capital injections would strengthen banks directly, by increasing the buffer available to absorb losses. In contrast, purchases of troubled assets would strengthen banks indirectly and only to the extent that they raised the prices of the assets that banks held.

On October 1, when we had lunch with President Bush, Hank himself had raised the possibility of using some TARP funds to provide new capital to banks as well as for purchasing assets. The TARP legislation was written broadly enough to permit either strategy or both, and Hank was keeping his options open. But, within a week after the president signed the TARP, Hank had clearly shifted away from asset purchases. Whatever the merits of the strategy in the abstract, it was becoming clear that financial markets and the economy were deteriorating too quickly. There just wasn’t enough time to design and implement an effective asset-purchase program.

It probably helped that the British, led by Prime Minister (and former finance minister) Gordon Brown, also appeared to be converging on a plan that included government capital injections via purchases of stock in large banks. They announced their plan on Wednesday, October 8. On the same day, Paulson met with journalists and released a statement noting that, among other authorities, TARP gave the Treasury the power to put capital into banks. “We will use all of the tools we’ve been given to maximum effectiveness, including strengthening the capitalization of financial institutions of every size,” he said.

Economists and editorial writers generally approved of recapitalizing banks, but the political

blowback was fierce. As we met with legislators, Hank and I had emphasized the need for flexibility to adapt to changing circumstances. News reports had noted that the TARP legislation encompassed a variety of approaches, including capital injections. Senator Dodd had pointed that out at his committee’s September 23 hearing. Nevertheless, many members of Congress regarded the new emphasis on capital injection as a bait and switch. Fair or not, that perception further increased politicians’ animosity toward the TARP.

In retrospect I wonder whether I should have insisted earlier and more vigorously on persuading Congress to accept capital injections. Perhaps so, although Hank’s arguments about political feasibility and possible market reactions rang true to me at the time. In any case, the initial emphasis on asset purchases was not a ploy: We and the Treasury had made a serious effort to implement an asset-purchase program. Fed staff had worked diligently to find an approach that would both stabilize the financial system and treat taxpayers fairly. But they ultimately concluded that, given the difficulty of establishing fair prices for complex, diverse assets, an effective program might take the Treasury many weeks to set up. Another staff concern was that, with more and more assets coming under suspicion, spending every penny of the $700 billion in TARP money on toxic assets might not be enough to stabilize the system. Providing $700 billion of new capital, on the other hand, would increase the capital of the banking system by half or more, reassuring creditors and customers and bolstering banks’ confidence to lend. If strengthening financial institutions stimulated private investors to put capital into banks as well, then so much the better.

As Hank showed increasing openness to capital injections, a Board staff team—led by David Wilcox —developed alternative implementation strategies. One approach, co-investment, aimed at involving private investors. Bank regulators and the Treasury would determine which banks needed capital, then capital-short banks would have a chance to find private investors. Those that could not would be required to take TARP capital. Hank liked the co-investment idea but ultimately opted for a simpler, government-capital-only plan on the grounds that, in the fall of 2008, capital markets were effectively closed to the great majority of banks. However, the basic approach that Wilcox and his team developed would resurface later.

I was glad that Hank was now prepared to use TARP to put capital into banks. I expected that fatter capital cushions, by reducing the risk of bank failures, would reduce fear and panic in the markets. But I also knew that in chaotic conditions, when asset values swing wildly, increased capital alone may not restore confidence. Government guarantees might also be needed. We had seen how a Treasury guarantee had ended a run on money market funds a month earlier, and FDIC-insured depositors had stayed with their banks throughout the crisis. But, in the twenty-first-century banking system, deposits were only one avenue for bank financing. Recognizing that, Britain, Ireland, and Greece had begun guaranteeing all bank liabilities (including longer-term debt) as well as deposits.

The Fed, though it could lend to banks against good collateral, had no authority to guarantee their

debts directly. I discussed, with Fed staff, an idea for indirectly guaranteeing short-term interbank loans, a narrow subset of transactions. Instead of lending directly to each other, banks could use the Fed as an intermediary. The lending bank would make a deposit at the Fed, which would in turn lend to the borrowing bank. The use of the Fed as an intermediary would eliminate the consequences (for the borrowing bank) of a default by the lending bank and thus possibly revive the market for short-term interbank loans. This strategy, though it appeared to be legally permissible, looked to be operationally unwieldy and difficult to implement reasonably quickly. Fortunately, a better and more natural alternative surfaced. The FDIC had potentially broad guarantee powers, if it chose to use them.

Hank and I met with Sheila Bair on Wednesday, October 8, at the Treasury (with Tim Geithner on speakerphone). We hoped to persuade Sheila to guarantee the liabilities of the entire banking system through the deposit insurance fund. To do that, her board would have to join the Fed and the Treasury in declaring a systemic risk exception for all banks—not just one bank, as we had done to facilitate Citigroup’s ultimately scuttled acquisition of Wachovia. Sheila, who became pricklier as events pushed her into taking steps further out of her comfort zone, has described the meeting as an “ambush.” I wouldn’t call it that. Our goal was only to broach the subject to the policymaker who, in this case, had the authority to act. We certainly did not expect an immediate commitment.

And Sheila was indeed noncommittal. She said she doubted that, even after declaring a systemic risk exception, she had the legal authority to guarantee all bank liabilities. She also doubted that her $35 billion deposit insurance fund would prove a credible backstop for trillions of dollars of bank debts and deposits. We pointed out that if broad guarantees helped prevent future bank failures, the deposit insurance fund would be far more secure.

The next morning, Sheila emailed Hank, Tim, and me. Upon reflection, she had concluded that blanket guarantees of the system were not necessary. Her staff believed that banks had enough capital and earnings to cover anticipated losses, which should be sufficient to restore confidence over time. She worried that bank guarantees could have unintended consequences, including sucking money away from money market funds. (I believed that the Treasury’s guarantee of money funds had alleviated that concern.) She was also concerned that weak banks might use guaranteed funds to finance go-for-broke risk taking, keeping the profits if they were lucky and dumping the losses on the deposit insurance fund if they were not. She concluded that it was better to use TARP funds to both invest in bank stock and provide any guarantees of bank liabilities that the Treasury deemed necessary. The FDIC could then fulfill its normal function of dealing with individual bank failures, which she saw as likely to remain manageable.

Tellingly, nowhere in the email did she argue that the FDIC lacked the necessary authority; and, despite her reservations, Sheila and her staff were working seriously on a guarantee plan. On Friday she sent a counterproposal. The FDIC would invoke the systemic risk exception and guarantee newly issued bank debt only—not existing debt, and not debt issued by bank holding companies. The guarantee would

require a 10 percent co-pay by investors. That is, if a bank defaulted on debt covered by the guarantee, the investor would be on the hook for 10 percent of the loss. Also, the FDIC would cover senior debt only, not lower-priority debt, such as subordinated debt. (Subordinated, or junior, debt cannot be repaid until the claims of senior debt–holders are fully satisfied.) Banks would pay fees for the FDIC guarantees. In addition, the FDIC would insure accounts, such as business checking accounts, that were not already covered by regular deposit insurance.

The Fed had traditionally opposed expanding deposit insurance, on the grounds that it would increase moral hazard. But during the crisis, insuring checking accounts used by businesses, municipalities, and nonprofit organizations, at least temporarily, made a lot of sense. Without it, these entities might rapidly shift their deposits from smaller banks perceived to be at risk to banks perceived as too big to fail. However, imposing a 10 percent co-pay on the debt guarantee and excluding the liabilities of bank holding companies didn’t seem workable. Potential bank debt buyers wouldn’t want to risk even 10 percent of their money, particularly since they had the alternative of buying the debt of banks in Europe, where some countries had already fully insured all bank liabilities.

Negotiations continued for several days. With a lot of hard staff work, we reached an agreement. On October 13, the FDIC board unanimously invoked the systemic risk exception and approved broad guarantees. The Fed’s Board invoked the exception the same day. The FDIC would fully insure new senior debt issued by both banks and their holding companies (no 10 percent haircut) for maturities of more than thirty days and less than three years. Coverage under the Temporary Loan Guarantee Program (TLGP), as it would officially be called, was free for the first month. To leave the program, banks had to actively opt out (few did). Participating banks paid moderate fees for the protection, with higher fees for guarantees of longer-term debt. As Sheila had originally suggested, the plan also extended deposit insurance to accounts used by businesses, governments, and nonprofits. I sent Sheila a letter promising that Fed supervisors would watch vigilantly for risky behavior by banks whose debts had been guaranteed.

In time, 122 banks and bank holding companies would issue $346 billion in guaranteed debt under this program, giving banks the security of longer-term funding and shoring up confidence in the banking system. The FDIC lost $150 million on its debt guarantees and $2.1 billion on the extended deposit insurance, but it collected more than $11 billion in fees, for a net gain to its insurance fund of $9 billion.

EVERYTHING STILL SEEMED to be happening at once. While the discussions about capital injections and bank guarantees were progressing, the Fed was also busy working on a new program to support the commercial paper market. Since the eruption of the crisis in 2007, lenders had become very cautious about buying commercial paper, funding only the most creditworthy issuers. Money market funds had become particularly skittish buyers after Lehman defaulted on its commercial paper. From just before Lehman weekend to the middle of October, commercial paper outstanding had fallen by about one-sixth,

Date: 2016-04-22; view: 532