Federal Reserve documents 25 page

or $300 billion. Maturities on more and more of the paper had shrunk to a day or two, increasing the risk that borrowers would be unable to roll over their financing.

September 2008 was not the first time that dysfunction in the commercial paper market had prompted Fed action. In June 1970, the railroad company Penn Central unexpectedly declared bankruptcy and defaulted on its commercial paper. Worried lenders soon refused to roll over the paper of many other firms; corporate borrowing in the commercial paper market dropped by more than 9 percent over the next three weeks. The Fed stemmed the slide by lending to banks through its discount window and encouraging the banks, in turn, to lend to customers that had lost access to the commercial paper market.

In 2008, though, discount window lending to banks wasn’t likely to help. Banks were lending as little as possible. We needed a more direct way to backstop the commercial paper market. We could invoke our emergency 13(3) authority and lend directly to firms unable to roll over their commercial paper, but that seemed a step too far. We wanted to restore the proper functioning of the commercial paper market, not replace it with our own lending.

In the Bear Stearns rescue, we created a legal entity to hold some of Bear’s risky assets, and the Fed lent to that entity. Several staff meetings with lots of blue-sky thinking, at both the Board and the New York Fed, led to the proposal of a similar solution. The Board could create a new legal entity called the Commercial Paper Funding Facility, or CPFF, which could buy commercial paper with funds provided by the Fed under its 13(3) authority. Hank and I had discussed the basic idea at our October 1 lunch with the president.

We needed to break the mentality that was prompting commercial paper buyers to lend for only a few days at a time (if they were willing to lend at all). Buyers lending at very short maturities hoped to be the first to the door if anything went wrong, leaving the buyers who had lent at longer maturities holding the bag. It was yet another example of run psychology. With the Fed acting as a backstop for commercial paper, including commercial paper with longer maturities, we might be able to restore confidence to both lenders and borrowers.

We soon faced an unexpected hitch. Loans made by the Federal Reserve, we knew, must be “secured to the satisfaction” of the Reserve Bank making the loan—in the case of the CPFF, the New York Reserve Bank. Firms that issue commercial paper are legally obligated to repay, but by longstanding practice the paper is rarely backed by explicit collateral, such as marketable securities. Could a loan to the CPFF, whose only assets were commercial paper, be considered adequately secured?

When we announced our plan to create the CPFF, we thought we had the solution to that problem. I had asked Hank to contribute TARP money to the new facility. If the TARP funds were first in line to absorb losses, then Fed loans to the CPFF would be adequately secured, meeting the legal requirement. Hank appeared to react positively, and we had counted on TARP money to make the CPFF work. But, to my chagrin, either I misunderstood Hank or he and his staff changed course. Over the next few days Fed staff and Treasury staff talked but didn’t reach agreement. Paulson later wrote that he declined to put

TARP funds in the CPFF because he hadn’t wanted the revamped commercial paper facility to be the TARP’s first program, although why that was such an important consideration I don’t know. Hank did like the general approach we proposed, though, and it became a model for later Fed-Treasury collaborations.

We had already announced the CPFF, and now, unexpectedly, TARP money was unavailable. We scrambled to find a way to ensure that our loans to the facility would be adequately secured. It took some lengthy meetings and calls, but eventually we found a workable formula. First, we stipulated that the CPFF would be allowed to buy only the most highly rated commercial paper (which, unfortunately, left out some important companies). We also required firms that wanted to sell their commercial paper to the facility to pay an up-front fee and an interest rate high enough to hasten their return to the regular market as conditions normalized. The fees were put in a reserve against possible losses. Finally, we limited our risk by capping the amount of commercial paper any one firm could sell to the CPFF. With these conditions in place, the Board and the New York Fed were willing to stipulate that loans to the CPFF were adequately secured. During its existence, the facility would suffer no losses and turn a profit for taxpayers, collecting $849 million in fees.

DURING THE CONGRESSIONAL debate around TARP, many lawmakers, especially Democrats, had argued passionately for helping homeowners facing foreclosure. As passed, the TARP bill required the government to modify mortgages it acquired through asset purchases. More importantly, the bill also authorized the use of TARP money for foreclosure prevention programs.

These provisions were just the latest effort to do something about the foreclosure epidemic. In July, Congress had also passed a program, called Hope for Homeowners—not to be confused with Hope Now, the voluntary private-sector initiative from the year before. H4H, as the new program was known inside the Beltway, authorized the Federal Housing Administration to refinance up to $300 billion of troubled mortgages, after imposing losses on the private-sector holders of the mortgages. At the Fed, we thought that the approach, advocated by Barney Frank and others, was promising. Refinancing would take the troubled mortgages off lenders’ books (after appropriate recognition of losses) while reducing monthly payments for borrowers. The Fed, along with other agencies, was assigned to oversee the program. Betsy Duke, who was now spending much of her time on housing issues, represented the Board.

The program failed. Only a few hundred borrowers even applied. Crucially, Congress had been unwilling to spend much on loan modifications. It made the terms for FHA refinancing unattractive for lenders, who mostly refused to participate. Congress’s tightfistedness was a nod to fiscal rectitude, but it also reflected the fact that many people apparently regarded helping troubled homeowners as “one more bailout” of irresponsible actors. I found that attitude remarkable. By this time the foreclosure epidemic had spread well beyond those who had knowingly purchased homes they could not afford. With the economy tanking and credit drying up, millions of people were either having trouble making their mortgage payments or knew someone who was. Moreover, helping troubled borrowers could benefit not

only the borrowers themselves but also neighborhoods blighted by foreclosed homes, the broader housing market (where foreclosures and forced sales were depressing prices and construction), and the overall economy.

AS WE WORKED to implement new programs at home, I kept a close watch on the economies and financial systems of our trading partners. The cold wind was blowing very strongly abroad, particularly in Europe.

I continued urging other major central banks to join us in a coordinated interest rate cut. I believed that the rate cuts themselves would support global economic growth and that the demonstration of unity would cheer the markets. When I had talked to Mervyn King and Jean-Claude Trichet on September 26, they had been interested but had also had reservations. The European Central Bank in particular had still been nervous about inflation. However, as financial conditions and the economic data worsened, resistance melted. Other central banks wanted to join in.

A coordinated rate cut presented tricky logistical problems. Each central bank involved had to arrange a special meeting or conference call with its policy committee. Then we had to coordinate the timing and wording of our announcements, all without giving any hint in advance of the market-moving news that was coming.

The Federal Open Market Committee met by videoconference late in the afternoon of Tuesday, October 7. Two FOMC hawks—Richard Fisher and Charles Plosser—happened to be in New York, so they joined Tim Geithner at the New York Fed for the call. “I just wanted to point out that I have assembled a historic coalition in New York of hawks on both sides of me today,” Geithner joked. Fisher, ever the Texas chauvinist, deadpanned, “Mr. Chairman, we enjoy visiting Third World countries.” And Plosser responded, “We just thought we would outflank him, but we haven’t succeeded.”

Small levities aside, the meeting had a dark tone. Bill Dudley described an “extremely dangerous and fragile” financial environment. In addition to more than doubling the cap on our swap lines with other central banks, to $620 billion, we had responded with a sixfold increase in scheduled auctions of discount window credit to banks in the United States—to $900 billion. The goal, as always, was to ensure banks access to funding despite the turmoil in credit markets. The huge amounts showed the size of the problem. But, despite all our efforts, panic persisted and credit remained frozen.

I told the FOMC that the financial situation posed enormous and growing economic risks. A coordinated response, showing the resolve and cooperation of major central banks, could have a stronger effect on the U.S. and global economies than if we acted alone. I also believed that concerted action could provide cover for other central banks to cut rates, notably the ECB, which was heir to the hawkish tradition of Germany’s Bundesbank. The FOMC voted unanimously to cut the federal funds rate by a half percentage point, to 1-1/2 percent.

The back-and-forth on the choreography with other central banks culminated in a call that included me, Trichet, King, Mark Carney of the Bank of Canada, and Masaaki Shirakawa of the Bank of Japan.

Finally, on October 8, at 7:00 a.m. New York time, the Fed, the European Central Bank, the Bank of England, the Bank of Canada, the Swiss National Bank, and Sweden’s Riksbank each announced interest rate cuts of half of a percentage point.* The Bank of Japan, with its policy rate already near zero, expressed strong support. We did not coordinate with the People’s Bank of China, but it, too, cut rates that morning. It felt good to pull off such a complicated piece of theater. The psychological effect of the world’s major central banks acting in concert would, I hoped, prove as important as the stimulus provided by the rate cuts themselves.

Yet as dramatic as the coordinated rate cut was, it did not solve the global financial system’s fundamental problems: unremitting panic and growing unease about the health of major financial institutions. The Dow Jones industrial average rose 180 points after we announced the coordinated cuts but ended down 189 points, or 2 percent, for the day. Markets were sending an unmistakable signal: More force was needed, and soon.

SO FAR, THE global response—outside of central banks—had largely been ad hoc and country by country. The Europeans had bailed out even more financial firms than we had but had not developed a comprehensive response. German rhetoric about the moral hazard of bailouts—despite the rescues of Hypo Real Estate and IKB—hamstrung cooperation on the continent. Meanwhile, some countries were complaining about spillover effects. When Ireland announced on September 29 that it was guaranteeing the deposits and debt of its banks, the British worried that Irish banks would drain funds from British banks. That led the British to follow nine days later with their own guarantee of bank liabilities.

Some small countries with large banks simply lacked the resources to go it alone. For example, tiny Iceland, with its 300,000 people, was also home to three large banks with operations extending to other Nordic countries, Britain, and the Netherlands. By early October, all three banks had collapsed, wiping out their shareholders (mostly domestic) and bondholders (mostly foreign). We had declined Iceland’s request for a currency swap line, as did the European Central Bank and Bank of England. Iceland’s financial institutions had few ties to U.S. financial institutions, and their problems were in any case too severe to be solved by currency swaps.

An opportunity to strengthen global cooperation arrived on Friday, October 10, as the world’s finance ministers and central bank governors converged on Washington for the regular fall meeting of the member countries of the International Monetary Fund (IMF) and the World Bank. The two institutions, which trace their origins to an international conference in Bretton Woods, New Hampshire, in 1944, were intended to promote international economic cooperation, with the IMF focused on maintaining economic and financial stability and the World Bank on fostering growth in developing countries. With 188 nations as members, these institutions had also become important venues for international consultation and policy coordination.

A series of smaller meetings led up to the broader gathering. First, on Friday, was the Group of Seven

(G-7): the United States, Canada, Japan, France, Germany, Italy, and the United Kingdom. On Saturday, the larger G-20 would meet. In addition to the major industrial countries, it included the most important emerging-market economies, among them China, India, Brazil, Mexico, and Russia. The G-20’s policy role had been growing with the global economic weight of the emerging-market economies. However, because the G-7 countries were home to most of the world’s largest financial institutions and financial markets, I expected that on this occasion the G-7 meeting would be the more important. It turned out to be the most consequential international meeting that I would attend during my time as Fed chairman.

We met in the Treasury Department’s Cash Room, a two-story marble hall with enormous brass chandeliers directly across from the Treasury’s main entrance. Opened for business in 1869, it was used for financial transactions with bankers and the public through 1976. Now it was the scene of formal events and social gatherings. For the G-7 meeting, long tables had been arranged in a square, with country placards at the seats. Interpreters were available but not necessary for the U.S. delegation; all discussions would be in English. Deputies and assistants moved in and out of the room, and aides, security agents, and other support personnel milled about in the hallway outside. As was customary, Paulson, the finance minister of the host country, presided.

International meetings are often sleepy affairs, occasions useful primarily for policymakers and senior staff members to maintain communications with their international counterparts. The same agenda topics recur meeting after meeting. The same platitudes are repeated. Deputies write and agree in advance to the postmeeting communiquй, drafted in fuzzy bureaucratic language aimed at winning unanimous support.

The tone of this meeting was anything but sleepy. Unlike no previous moment since the 1930s, the global economic system itself seemed at risk. Most of the finance ministers and central bank governors assembled blamed the United States for the crisis. Whose financial deregulation had subjected the world to the depredations of “cowboy capitalism”? Whose subprime mortgages had infected the assets of financial institutions around the world? Who had let Lehman fail? On this last point, Jean-Claude Trichet, in his ringing Gallicized English, was particularly eloquent, passing around a chart that showed the sharp deterioration in funding markets that had occurred after Lehman weekend. Others echoed Jean-Claude, and for a moment it seemed the meeting might degenerate into finger-pointing.

In a global crisis, the United States was the natural leader. But our country’s prestige and credibility were at a low ebb. The early schadenfreude of other advanced countries at the U.S. crisis had morphed into anger when the effects of the crisis spread globally and gathered force. Who were we to give advice? We heard this message both from the G-7 and, perhaps even more consistently, from emerging-market officials at the G-20 meeting on Saturday.

Despite those tensions, the G-7 representatives were determined to work together. Too much was at stake for the group to leave Washington without at least the outlines of a coordinated response. And, despite some testy rhetoric, the people at the table respected each other. We knew we were among the few who could stop the bleeding. Breaking protocol established over many years, we ignored the meeting

agenda and launched into a freewheeling and substantive discussion.

I had been thinking about what should be done for some time. On the Wednesday before the meeting I had finished drafting a set of principles that I hoped the G-7 would adopt. They were basic, but I believed they encompassed the responses that had calmed panics many times in the past. In brief, I wanted the assembled officials to pledge to cooperate to stabilize financial markets, restore the flow of credit, and support global economic growth. Toward those objectives, I wrote, the countries represented at the meeting should provide necessary short-term loans and capital for their banks, collaborate on supervising banks operating internationally, and permit no more failures of systemically important institutions. And I wanted us to pledge to restart critical markets for mortgage-backed securities, commercial paper, and interbank lending. With Treasury’s support I submitted my list of proposed policy commitments to the deputies working on the communiquй.

The principles resonated with the ideas that others brought to the table. In the final statement issued by the G-7, my initial list was shortened to five points. First, the member nations promised to prevent more Lehmans—that is, to prevent more failures of systemically important institutions. (The United States could credibly make this promise after the enactment of TARP.) Second, we pledged to work to unfreeze funding markets (the Fed’s commercial paper facility being an example of such an attempt). Third, we committed to recapitalizing banks to promote the flow of credit. Fourth, we said we would put deposit insurance in place to protect ordinary depositors and maintain confidence in banks. (This point was not on my original list because the United States had long had federal deposit insurance. But it was an issue for Europe, where most countries lacked comprehensive deposit insurance.) And, fifth, we promised to work to restart securitization, so that mortgages and other types of credit could be funded by investors.

The participants left the G-7 meeting with their resolve restored. In the United States, we were moving beyond the ad hoc responses of the pre-Lehman period. Mobilization had been slow, but I believed we now had the chance to mount a systematic attack on the crisis at the global level.

GLOBAL POLICYMAKERS LIVED up to their promises. Most importantly, on Sunday evening the eurozone countries agreed to implement capital injections and guarantees for their banks. Austria, France, Germany, Italy, the Netherlands, Portugal, Spain, and Sweden announced bank debt guarantees similar to the one proposed by the FDIC in the United States. An even larger group expanded their deposit insurance systems. A few countries, including Norway and Spain, announced that they would buy assets as well. On Monday, the United Kingdom essentially nationalized two of its largest banks, the Royal Bank of Scotland and HBOS. For the most part, the plans adopted followed the G-7 principles.

In the United States, work on Treasury’s plan to recapitalize banks, dubbed the Capital Purchase Program (CPP), continued into Columbus Day—Monday, October 13. With Paulson’s change of heart, the Fed and Treasury were now on the same page with regard to the need to inject capital into banks, and the FDIC and the Office of the Comptroller of the Currency agreed to support that approach. To avoid stigma,

which could be fatal to our plans, we wanted a program that would appeal to all banks, not only weak ones. If accepting CPP capital was perceived as a sign of weakness, then banks would do all they could to avoid taking it, and we would not be able to put enough capital into the system to end the panic and restart the flow of credit. We needed to set conditions that were fair to taxpayers but not so punitive that they dissuaded stronger banks from accepting capital.

We also needed to avoid the appearance of a government takeover of the banking system, one of Paulson’s original concerns. We agreed that capital injections would take the form of the government purchasing newly created, nonvoting preferred stock. Because the stock was nonvoting, the government wouldn’t control the operations of the banks receiving help, except for the executive pay restrictions required by the TARP bill. Because the government’s stock was preferred, it would be first in line to receive dividends, ahead of common shareholders. In addition, as required by the legislation, the government would receive warrants that would allow taxpayers to share the gains if bank stock prices rose. The government would receive a dividend on its shares of 5 percent per year for three years. The dividend would then jump to 9 percent to encourage banks to replace government capital with private capital, which we hoped would be plentiful by that point.

To ensure widespread participation, including by stronger banks, we needed the nation’s leading banks to take part. (I was reminded of our efforts to bring banks to the discount window in August 2007.) Hank summoned nine CEOs to his large conference room on Columbus Day afternoon. On one side of the room’s long oval table sat Jamie Dimon of JPMorgan, Dick Kovacevich of Wells Fargo, Vikram Pandit of Citigroup, Ken Lewis of Bank of America, Lloyd Blankfein of Goldman Sachs, John Mack of Morgan Stanley, John Thain of Merrill Lynch, Ronald Logue of State Street, and Bob Kelly of Bank of New York Mellon. Paulson, Sheila Bair, Tim Geithner, Comptroller of the Currency John Dugan, and I sat across from the CEOs. Hank and I said it was important that strong as well as weak banks participate. Sheila told the CEOs about the bank debt guarantees. Tim reviewed the amount of capital proposed—up to 3 percent of each bank’s risk-weighted assets. Hank asked the CEOs to commit to taking the capital, consulting with their boards as necessary.

John Mack of Morgan Stanley scrawled his acceptance immediately on a sheet of paper and pushed it across the table. Dick Kovacevich of Wells Fargo, feisty as always, insisted his bank didn’t need any capital but finally agreed to consult his board. Vikram Pandit said that this was cheap capital and the banks should be glad it was available. Ken Lewis of Bank of America urged the group not to haggle over details but to go along in the interest of the system. Ultimately, all the banks took the recommended amounts of capital, totaling $125 billion, or half the $250 billion initial commitment to the Capital Purchase Program. Merrill Lynch, which would declare large losses later that year, took its own tranche of capital even though it was scheduled to be acquired by Bank of America.

The news from Europe and leaks about the new capital program in the United States created euphoria on the stock market. On Monday, the Dow Jones industrial average jumped 936 points (11 percent) to

9,387—partially recovering from the previous week’s 1,874-point loss. It was the index’s largest one-day gain in percentage terms in seventy-six years.

ON TUESDAY MORNING, Hank, Sheila, and I stood in the Treasury’s Cash Room at a press conference. Paulson described the new Capital Purchase Program. Asset purchases were still on the table but would be delayed. Sheila described the FDIC’s expansion of deposit insurance and its program to guarantee bank debt. Finally, I elaborated on the Fed’s Commercial Paper Funding Facility, which would begin purchasing commercial paper in two weeks, on October 27.

We were still months away from stability, but, together with the steps taken abroad, a coherent and powerful strategy was finally taking shape.

* After the cuts, the policy rates at the other central banks were: ECB, 3-3/4 percent; Bank of England, 4-1/2 percent; Bank of Canada, 2-1/2

percent; Sweden’s Riksbank, 4-1/4 percent.

CHAPTER 17

Transition

When Barack Obama defeated John McCain on November 4, 2008, I marveled that the election of the first African American president came less than forty years after I had attended segregated schools in Dillon. I also was reminded of the economic uncertainty caused by the four-month transition between the Hoover and Roosevelt administrations in 1932–33, which prompted a constitutional amendment that shortened by two months the wait between the election and inauguration of a new president. Even with this shorter transition, the handoff from George W. Bush to Barack Obama would complicate the management of a crisis not yet under control. At the Federal Reserve, exempt from the wholesale personnel changes facing the Treasury and other cabinet departments, we resolved to provide as much policy continuity as possible.

Important decisions loomed. Should the Bush administration ask Congress for the second half of the TARP funds? Should TARP money be used to help struggling auto companies? What could be done to assist homeowners behind on their mortgage payments? On these and other matters, the incoming and outgoing administrations had to figure out how to cooperate without violating the maxim that there can only be one president at a time.

IN THE MEANTIME, Paulson focused on getting Treasury’s Capital Purchase Program up and running. The nine large banks represented at the Treasury Department’s October 13 meeting had taken $125 billion in new government capital, leaving half of the $250 billion allocated for other banks. It took some time to work out the details about how to provide capital to smaller institutions. It was not a given that banks would willingly participate, but demand for TARP capital was strong from banks of all sizes, and by the

end of 2008, the Treasury’s investments in banks were approaching $200 billion.

The capital program was a major step forward in stabilizing the banking system. And it didn’t seem particularly unpopular with the broader public, by the standards of crisis-era programs. Executive compensation limits at firms receiving government capital helped politically, without being so tight that they discouraged broad participation. It also helped politically that banks of all sizes, including community banks, could avail themselves of government capital, so long as their regulators judged them to be viable. Still, politicians, worried about defending their vote for the TARP, pressed the Treasury and the Fed for evidence that the capital program was working. The question was most often phrased, “Are banks lending the money they’re getting from TARP?”

It seems like a simple question, but it’s not. Money is fungible: One dollar is like any other. Consequently, asking whether a particular loan is made with a TARP dollar or some other dollar the lender obtained elsewhere does not mean much. Moreover, capital’s purpose is mainly to absorb possible losses, which in turn makes banks more willing to risk making loans. A better way to ask the question would have been, “Is the availability of TARP capital allowing banks to make more loans than they otherwise would have made?”

Even that question was difficult to answer. How could we prove a counterfactual—what would have happened if there were no TARP? I had no doubt that the TARP, together with all the other measures, had prevented a financial meltdown that would have plunged the economy into an extraordinarily severe and protracted recession, or even a depression. True, bank lending after the introduction of the capital program was much lower than before the crisis, but that was hardly a fair comparison. The recession greatly reduced the number of businesses and households seeking credit and the number of those who could qualify for credit in the first place.

A Board staff team, led by senior economist Nellie Liang, gathered data and developed metrics for assessing the TARP’s effect on bank lending. But we never found a measure that was both comprehensive and easy to explain. Moreover, while we wanted banks to lend, we didn’t want them to make bad loans. Bad loans had gotten us into the mess in the first place. For that reason, setting lending targets for banks who took TARP capital, as some politicians advocated, didn’t seem wise. Our strategy, admittedly difficult to explain in a sound bite, was to lean against the excessive conservatism of lenders and examiners that typically followed a lending boom and bust. With the other federal bank regulators, we encouraged banks to lend to creditworthy borrowers. We also pressed our examiners to strike an appropriate balance between encouraging reasonable prudence and ensuring that creditworthy borrowers could get loans.

Date: 2016-04-22; view: 644