Federal Reserve documents 16 page

But the biggest risks lay in the $2.8 trillion tri-party repo market. (In the tri-party repo market, a clearing bank intermediates between repo lenders and borrowers. In the very large and quite opaque bilateral repo market, investment banks and other financial firms arrange repo transactions among themselves. Bear borrowed mostly in the tri-party market.) When Bear’s repo lenders refused to renew their loans, JPMorgan, as the company’s clearing bank, would face a stark choice: either lend to Bear itself and risk tens of billions in JPMorgan shareholders’ dollars, or start selling the collateral on behalf of Bear’s creditors. A decision to dispose of the collateral in a fire sale (the likely outcome) would, in turn, drive securities prices further down, leading to a new wave of losses and write-downs. Worse yet,

others in the tri-party repo market, fearful of losses or of having their funds tied up, might resolve not to lend to any borrower. The remaining four major investment banks would be particularly vulnerable, and the failure of Bear could lead to runs on those firms as well. My own greatest fear, if Bear collapsed, was that the repo market might break down entirely, with disastrous consequences for financial markets and, as credit froze and asset prices plunged, for the entire economy.

Baxter’s lending plan offered a means of getting Bear to the weekend, when we’d have breathing room to work on a longer-term solution. As Scott Alvarez advised, though, we would take the extra step of invoking our 13(3) authority to make the loan. I insisted, also, that the Fed could not go further without the administration’s agreement. We felt reasonably confident we’d be repaid if we made a collateralized loan to Bear, but it was a risk nonetheless. If we weren’t repaid, taxpayers would suffer. Thus, the plan under discussion was at least partly a fiscal matter. Hank excused himself to check with President Bush, rejoining the conference call a short while later. We had the president’s support.

At around 7:00 a.m. it became clear that time was running out. As Tim reminded us, the repo markets would open at 7:30 a.m. The Federal Reserve was the only institution with the authority to intervene and I was its head. I had listened carefully on the call. I saw many risks, but the risks to the repo market—a market few Americans had even heard of—loomed largest. “Let’s do it,” I said. After covering a few operational issues, I hung up the phone, finished getting ready for work, and walked out the door to the waiting security detail. I emailed Rita Proctor, “Pls order a couple of muffins and oj for me. I’ll be in in 10 mins.”

At 9:15 a.m., the Board met and voted, 4–0, to authorize the New York Fed to lend to JPMorgan so it could provide financing to Bear Stearns. Since we had invoked 13(3), we could have lent directly to Bear, but the paperwork prepared in New York overnight, in line with Baxter’s idea, was for the back-to-back loan. There wasn’t time to draw up new documents. The Board also delegated to me its authority to permit the New York Fed to lend to other securities dealers if necessary. It wasn’t—at least that Friday. Though we had invoked 13(3) in creating the TSLF, the extension of credit to Bear was the first actual use of the authority to extend funds since 1936. Rick missed that vote as well. He was in transit from Finland. The Federal Reserve Act required five votes—but we had an out. An amendment added to the act as a precaution after the 9/11 terrorist attacks, when Roger Ferguson was the only Board member in Washington, permitted 13(3) actions on “the unanimous vote of all available members.”

Stocks plunged initially on the news, with the Dow falling as much as 300 points before recovering somewhat. Investors were wondering who was next. Bear’s share price fell to $30, from $57, and the run of its creditors and customers continued. We ended up lending the company $13 billion. But we got to the weekend. From there, it was a race to find a longer-term solution “before Asia opens,” specifically before Asia’s largest stock market opened Monday morning in Tokyo (Sunday evening in New York).

I SPENT A hectic weekend in my office, talking to staff and monitoring developments. Tim, the Fed’s eyes

and ears on Wall Street, stayed in touch with Dimon. We were looking to JPMorgan either to buy Bear or make an investment that would stabilize it. The private investment firm J. C. Flowers & Co. was also considering whether to make an offer. But it soon became apparent that only JPMorgan had the financial wherewithal to get the deal done before Monday. By Saturday evening, Dimon told Tim he was prepared to pay $8 to $12 a share for Bear’s stock. Meanwhile, Deborah Bailey, the deputy director of the Board’s banking supervision division, reported that the New York Fed would be sending teams to work with the SEC in reviewing the cash positions of the other big investment banks. “Monday looks like it will be a very difficult day for some of the IBs,” she wrote, “but particularly for Lehman.” Lehman was the fourth-largest investment bank and it was widely expected to be the next target of speculative attack if Bear went down.

On Sunday, Tim called. He had spoken to Dimon. The deal was off. Dimon wasn’t willing to take on Bear’s substantial subprime mortgage holdings. Tim started exploring with Paulson and Dimon what it might take to reverse the decision. As I was digesting the news, Michelle Smith forwarded an email from former Treasury secretary Larry Summers—her former boss in the Clinton administration (and Tim’s). Now a Harvard economics professor and a managing director at the hedge fund D. E. Shaw, Larry had emailed Tim but hadn’t heard back and was asking Michelle to pass on his message.

Larry is known for being blunt, to put it mildly, and he seemed to be warning against rescuing Bear. He said he had spoken at length to someone who had been inside the firm for most of Saturday. “The Fed may well be on a path that: 1) will fail to contain systemic risk, 2) will invite legitimately all kinds of charges of ‘helping friends,’ 3) be negative for moral hazard,” he wrote to Michelle. “Happy to explain to you, ben, tim or anyone else.” He continued, “At minimum please pass on to Ben the following: having embarked on unprecedented bear bail out, fed must succeed or its cred will be in tatters.” He concluded, “Good luck to you all. L.”

With Larry’s email, the “firestorm of debate” that Chris Dodd would reference at the April 3 hearing had already begun. Larry’s point about moral hazard was a good one. But he didn’t need to explain it to us. (Nor did he need to explain that, if we failed, our credibility would be in tatters. We knew that.) We wanted creditors that funded financial institutions, large as well as small, to be careful about where they put their money. That they might not, because they expected any failing firm to be bailed out, was the moral hazard problem. In the short run, though, we couldn’t risk a general panic in the repo market and other funding markets. The result, we knew full well, could be frozen credit flows, with all the consequences that would have for the economy and for ordinary Americans.

Senator Dodd offered to help over the weekend by calling Bill Daley, a friend of Jamie Dimon’s, with the goal of persuading Dimon to return to the negotiating table. Dimon apparently knew Daley, a Commerce secretary in the Clinton administration and a brother of Chicago Mayor Richard M. Daley, from his days at BankOne. As it turned out, we didn’t need Dodd to make the call. By early afternoon, Tim and Hank had worked out a deal with Jamie. JPMorgan would buy Bear Stearns, paying $2 each for

shares that had been worth nearly $173 in January 2007. With the need to contain moral hazard in mind, Hank had pressed for a very low share price. He did not want us to be perceived as bailing out Bear’s owners, its shareholders. Importantly, in the weeks ahead, during the wait for approval by the shareholders of both firms, JPMorgan would stand behind all of Bear’s obligations. Without a credible guarantee, the run on Bear Stearns would continue and the company might collapse before the acquisition could be consummated.

What changed Dimon’s mind about acquiring Bear? The answer would prove to be the deal’s most controversial aspect. To make the deal work, we agreed to lend up to $30 billion, without recourse, taking as our security $30 billion of Bear’s assets, mostly mortgage-related securities judged by the rating agencies to be investment-grade. Dimon had made clear that otherwise the deal would be too big and too risky for JPMorgan. BlackRock, an asset management firm headed by the veteran Wall Street analyst Larry Fink, was hired by the New York Fed to look at the assets. It advised that the Fed could reasonably expect to get its money back if it held the assets for several years. BlackRock’s assessment allowed Tim, the president of the Reserve Bank that would do the actual lending, to affirm that the loan was “secured to the satisfaction” of the Reserve Bank. Our judgment about the asset values was founded on our confidence that we would ultimately be able to stabilize the financial system. If we succeeded, then the value of the assets we were lending against should ultimately be sufficient to repay the Fed’s loan with interest. If we did not succeed, the outcome was uncertain. Because any losses to the Fed would reduce our payments to the Treasury, we would have liked the Treasury to guarantee our loan, but, without congressional authorization, it did not have the authority to do so. We settled for a promise of a letter from Paulson expressing the administration’s support.

That afternoon and evening, Don and I worked the phones, alerting counterparts around the world to our plans. I called Jean-Claude Trichet at the European Central Bank, Mervyn King at the Bank of England, and Toshihiko Fukui of the Bank of Japan. They were supportive, and relieved that Bear’s collapse would be averted. We also wanted my two predecessors as chair—often quoted by the press— to understand what we had done and why. Don called Greenspan and I called Volcker. “Spoke to him, he’s fine,” I reported back. Notwithstanding my assessment, Volcker would soon publicly express concerns.

The Board met at 3:45 p.m. on Sunday. In addition to declaring unusual and exigent circumstances and approving the loan against Bear’s $30 billion in assets, the Board also approved an important new lending facility—the Primary Dealer Credit Facility, or PDCF. It would allow the primary dealers to borrow from the Fed, just as commercial banks had always been able to do. And the collateral that we accepted for such loans would be much broader than the collateral accepted at the TSLF for a loan of Treasury securities.

We created the PDCF to reduce the risk of a disruptive failure of a primary dealer. And, having access to the PDCF should allow the primary dealers to “make markets”—that is, stand ready to buy and

sell financial assets. More liquid markets would function better and would reduce destabilizing price swings. We also hoped that, by effectively providing a backstop funding source for repo borrowers (primary dealers are both repo borrowers and repo lenders), we could promote confidence and keep that market functioning.

In addition to creating the PDCF, we opened the liquidity spigot another turn for commercial banks, increasing the maximum maturity of discount window loans from thirty days to ninety days. And we cut the discount rate (the interest rate on discount window loans) by 1/4 percent, to 3-1/4 percent—just 1/4 percent higher than the target for the federal funds rate.

In the months that followed our before-Asia-opens announcement, the New York Fed negotiated fiercely over the set of assets that would collateralize our loan, ensuring we would be protected as much as possible. In the meantime, Bear’s shareholders were so furious at the $2 share price that Dimon was worried that they would reject the deal when the time came to vote on it. He renegotiated and agreed to pay $10 a share, an offer that Bear’s shareholders accepted on March 24.* Tim and I had persuaded a reluctant Hank not to stand in the way of Dimon’s higher offer. It’s true that the lower price would have sent a stronger message: that we were interceding to protect the system, not the owners of the firm. But if Bear shareholders rejected the deal, it would be the night of March 13 all over again—with us wondering whether the American financial system would implode over the next few days.

We negotiated a better deal for the Fed as well. The $30 billion in Bear Stearns assets would be placed in a limited liability corporation created by the New York Fed, which would allow us to structure our assistance as a loan against collateral, as required by 13(3). It was named Maiden Lane LLC, after a street outside the New York Fed’s fortresslike building in lower Manhattan. We would lend $29 billion to Maiden Lane and JPMorgan would lend $1 billion. JPMorgan would take the first $1 billion in losses, if any. Of course, Maiden Lane looked uncomfortably like the off-balance-sheet SIVs that Citigroup and others had used to bet on subprime mortgages. One big difference was that we included it on the Fed’s balance sheet and reported publicly on its market value every quarter. The deal would work out for the Fed and taxpayers in the end. Our loan was repaid, with $765 million in interest; in addition, as of early 2015, Maiden Lane held assets worth an additional $1.7 billion in profit for the Fed and, consequently, for the taxpayer. The important thing was not the return on the loan—it was that the financial system and the economy, at least for a time, were spared enormous disruption.

The Bear rescue nevertheless was heavily criticized, especially after Dimon increased the offer to Bear’s shareholders. The commentary focused on the unfairness of bailing out Wall Street (a sentiment with which I agreed) rather than on what would have happened had we not acted. In an April speech, Paul Volcker declared that the Fed in the Bear Stearns deal had taken actions “that extend to the very edge of its lawful and implied powers, transcending in the process certain long-embedded central banking principles and practices.” I took slight comfort from the fact that he hadn’t said we had gone over the edge of our lawful power. Really, he was warning that the private-sector excesses and regulatory deficiencies

that had led to what he called “the mother of all crises” must end. I agreed with him about that, and also that we had gone to the edge of our lawful and implied powers. My concern was that those powers, even if pushed to the limit, might not be enough to handle the next blowup.

THE FOMC MET on March 18, two days after JPMorgan agreed to buy Bear Stearns. Dave Stockton and his staff explained why they now believed that the economy was entering a recession. In light of the worsening economic outlook and the ongoing financial stresses, I recommended a substantial rate cut of three-quarters of a percentage point, bringing the target for the federal funds rate down to 2-1/4 percent. The FOMC approved it, with two hawks—Richard Fisher and Charlie Plosser—voting no. On April 30, the FOMC would cut the rate another quarter point, to 2 percent.

The Bear Stearns action brought a period of relative calm to financial markets. In late March, the investment banks reported earnings that beat market expectations. In a vote of confidence in the U.S. financial system, big commercial banks and the investment banks were able to raise an impressive $140 billion in new capital by the end of June. Funding conditions improved, and borrowing through the PDCF by the primary dealers, after spiking above $37 billion in late March, shrank to zero by the start of July. The stock market reflected the better tone of credit markets. The Dow closed at 12,263 on March 31, virtually unchanged from its level before the Bear Stearns crisis. By May, the Dow had climbed to 13,058, within 8 percent of its October 2007 peak. Most importantly, the economy showed signs of modest growth. The Commerce Department on July 31 would report that the economy grew by almost 1 percent in the first quarter and a hair below 2 percent in the second quarter. With lower interest rates and the temporary tax cuts, we had at least some hope that the economy would avoid a recession after all.

ALL OF THIS was unknown on April 3 as I tried to explain, under the camera lights at the Senate hearing on Bear Stearns, why we had intervened. I knew that the more thoughtful senators on the panel understood— some of them would later tell me so—but the temptation to make political hay was too great for many.

Why were we bailing out Wall Street when so many ordinary Americans needed help?

Wall Street and Main Street are interconnected and interdependent, I explained. “Given the exceptional pressures on the global economy and financial system, the damage caused by a default by Bear Stearns could have been severe and extremely difficult to contain,” I said. And the damage would have surely extended beyond financial markets to the broader economy. Without access to credit, people would not be able to buy cars or houses, and businesses would not be able to expand or, in some cases, even cover current operating costs. The negative effects on jobs and incomes would be fast and powerful.

Why were we creating moral hazard by rewarding failure? (“That is socialism!” Senator Bunning had roared.) I pointed out that, even with our action, Bear Stearns lost its independence, its shareholders took severe losses, and many of its 14,000 employees likely would soon lose their jobs.

“I do not think it is a situation that any firm would willingly choose to endure,” I told Senator Tim

Johnson of South Dakota. “What we had in mind here was the protection of the financial system and the protection of the American economy. And I believe that if the American people understand that we were trying to protect the economy and not to protect anybody on Wall Street, they would better appreciate why we took the actions we did.”

One thing was clear. From now on we would be facing two challenges in dealing with the crisis. The first would be to do the right thing. The second would be to explain to the public and politicians why what we did was the right thing.

IN RETROSPECT, WAS it the right thing? Some economists have argued that it was a mistake. Our actions restored a degree of calm in financial markets, but for less than six months. Ultimately, much of what we feared would happen if Bear collapsed came to pass when Lehman Brothers filed for bankruptcy in September 2008. Some would say in hindsight that the moral hazard created by rescuing Bear reduced the urgency of firms like Lehman to raise capital or find buyers.

In making the decisions we made in March 2008, we could not know all that would transpire. But even in hindsight, I remain comfortable with our intervention. The enormously disruptive effect of Lehman’s failure in September, I believe, confirmed our judgment in March that the collapse of a major investment bank—far from being the nonevent that some thought it might be—would severely damage both the financial system and the broader economy. Our intervention with Bear gave the financial system and the economy a nearly six-month respite, at a relatively modest cost. Unfortunately, the respite wasn’t enough to repair the damage already done to the economy or to prevent panic from breaking out again in the fall.

I also believe that critics overstate the contribution of moral hazard from the Bear intervention to the resurgence of the crisis in the fall. As I told Senator Johnson, no firm would willingly seek Bear’s fate. And financial firms, including Lehman, did indeed raise substantial capital over the summer. Moreover, as nearly happened to Bear, Lehman was done in by an overwhelming run on the firm. The occurrence of the run shows that Lehman’s creditors and counterparties worried it would not be rescued. In other words, Lehman was subject to market discipline.

It cannot be denied, though, that these are difficult questions, and we would debate them among ourselves as spring turned to summer in 2008.

* Dimon had a further incentive to raise his offer: A lawyer’s drafting error committed JPMorgan to guarantee Bear Stearns’s liabilities for up to a year, even if the shareholders voted down the merger. The mistake increased Bear’s shareholders’ bargaining power.

CHAPTER 11

Fannie and Freddie: A Long, Hot Summer

The Bear Stearns rescue was followed by a period of relative calm, but we remained wary. Powerful destructive forces had been set in motion. Home prices continued to fall. More delinquencies and foreclosures were sure to follow—with the losses flowing through to mortgage-related securities. We did not know how large the losses would be or where they would show up. But we knew more shoes could drop.

Our bank supervisors would relay a steady flow of bad news all summer long. IndyMac, based in Pasadena, California, and the nation’s seventh-largest savings and loan, was teetering. It had been deeply involved in the Alt-A niche of the mortgage market, one level above subprime. IndyMac was overseen by the Office of Thrift Supervision. Since it had government-insured deposits, the FDIC monitored it as well. Normally we wouldn’t have been involved, but the possibility that IndyMac might come to the Fed’s discount window led the San Francisco Reserve Bank to dispatch two examiners. Based on their reports, Deborah Bailey of the Board’s banking supervision division told me on July 1 that she didn’t see how the company could survive much longer. “Retail deposits have been running since Friday, the company is tracking it hourly,” she wrote. “The company is shrinking and selling off assets as fast as it can.” Now, nearly a year into the financial crisis, even insured depositors could be spooked. Like a cadre of grim reapers, the FDIC’s specialists in bank resolution were preparing to seize the lender.

Even more than private-sector lenders like IndyMac, we were concerned about the world’s two largest holders of residential mortgages, the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac. Congress had created Fannie and Freddie to support homeownership. Both started out as federal agencies, Fannie during the Great Depression, in 1938, and Freddie in 1970. However, both were

later converted by Congress to shareholder-owned corporations—Fannie in 1968 and Freddie in 1989. Although legally private, Fannie and Freddie were regulated by and maintained close ties to the federal government, were exempt from all state and local taxes, and had a line of credit from the Treasury.

Their platypus status, as both private corporations and de facto government agencies, was flawed from inception. Effectively, the arrangement created a “heads I win, tails you lose” situation, with shareholders enjoying the profits earned by the companies but with taxpayers ultimately responsible for losses.

Fannie and Freddie had achieved some success in their mission to promote homeownership. They purchased mortgage loans from banks, savings institutions, and other mortgage originators and packaged the loans into mortgage-backed securities. They sold MBS to a wide range of investors, from insurance companies to pension funds to foreign central banks. For a fee, Fannie and Freddie guaranteed their MBS against borrower defaults, so purchasers faced no credit risk. Through bundling mortgages and selling the resulting securities, Fannie and Freddie allowed the world’s savings to pour into the U.S. housing market. This huge inflow likely made mortgages cheaper and easier to get, thereby promoting homeownership, although precisely by how much was contentiously debated.

The benefits of Fannie and Freddie, such as they were, came with significant risks to the housing market, the financial system, and the taxpayer. The greatest risks originated in what was probably a deliberate ambiguity on the part of Congress when it created the GSEs. Officially, if Fannie or Freddie went broke, the U.S. government had no obligation to protect those who had lent directly to the companies or purchased their MBS. Consequently, the federal budget did not recognize the risk of having to bail out one or both GSEs. In Washington, where the official figures shape reality, omitting this possible cost from the budget allowed successive Congresses and administrations to ignore it.

And yet, investors assumed that the government would never let Fannie or Freddie fail, for fear of the damage to the U.S. housing market, financial markets in general, and the economy. This belief in an implicit government guarantee in turn enabled the GSEs to borrow at interest rates not much above those at which the government itself could borrow. The regulator of Fannie and Freddie, the Office of Federal Housing Enterprise Oversight, following congressional instructions, had long required the companies to hold only small capital cushions against possible losses. Still, investors’ confidence in the GSEs and the implicit guarantee had remained largely unshaken through the ups and downs of the economy and the housing market.

Their ability to borrow cheaply made Fannie and Freddie hugely profitable in normal times. In one particularly lucrative strategy, they used the proceeds of their cheap borrowing to buy and hold hundreds of billions of dollars’ worth of MBS, including many of the very MBS they had issued and guaranteed. The rate the GSEs earned on the MBS they held was higher than the implicitly subsidized rate they paid to borrow. It seemed like the ultimate free lunch—an ongoing flow of profits with no apparent risk. Congress too shared in the free lunch, in that it could require the GSEs to use some of their profits to

support housing programs in members’ districts. Fannie and Freddie also spent some of their profits on lobbying and political contributions, cementing the cozy relationship. Their clout had largely protected them during a series of accounting scandals between 2003 and 2006, when earnings overstatements resulted in enormous bonuses for some of the companies’ top executives.

The companies also worked hard to maintain a good relationship with the Fed, notwithstanding (or perhaps because of) the concerns we often expressed about the risks they posed. We received regular research reports, some commissioned from prominent economists, that invariably concluded the GSEs were safe as houses, so to speak. Early in my chairmanship, I met with their executives and economists several times to discuss the housing market and the GSEs themselves. Both companies’ CEOs were relatively new at that point. Richard Syron, a former president of the Federal Reserve Bank of Boston, had taken over at Freddie Mac in late 2003. Bespectacled, with a heavy Boston accent, Syron seemed well aware of (and a little apologetic about) the inherent conflicts arising from the GSEs’ status. Daniel Mudd, a decorated former marine and the son of former CBS television news anchorman Roger Mudd, had taken the helm at Fannie a year later as interim CEO, following the resignation of Franklin Raines (a victim of Fannie’s accounting scandal). Mudd, more hard-charging than Syron, struck me as someone who would aggressively defend his company’s interests.

Critics, including the Government Accountability Office and the Congressional Budget Office, had often warned about the possibility that the government might one day have to bail out one or both GSEs. Alan Greenspan, with the assistance and urging of the Board staff, had spoken out frequently. When I became chairman, I continued the criticism, arguing that the GSEs’ low levels of capital posed risks both to the taxpayer and to the financial system as a whole.

When the mortgage crisis began in 2007, it appeared at first that the GSEs might help stabilize housing, as they and their supporters expected and promised. Investment banks and other private firms had been creating their own, unguaranteed mortgage-backed securities. In many cases, these so-called private-label securities were constructed out of mortgages—known as nonconforming mortgages—that the GSEs would not securitize, either because they were bigger than the maximum size legally allowed by Congress or because they did not meet the GSEs’ quality standards. Investor demand for new private-label MBS evaporated when the poor quality of many of the underlying mortgages was revealed. At that point, banks and other lenders originating nonconforming mortgages had no choice but to keep them on their own books. Most originators had limited capacity or desire to do so. That meant only conforming mortgages eligible for sale to Fannie and Freddie were available to sustain the housing market. In the summer of 2008, Fannie and Freddie owned or had guaranteed about $5.3 trillion in U.S. mortgages—about half of all those outstanding. With the demise of their private-sector competition, the GSEs had become even more indispensable.

Date: 2016-04-22; view: 799