Federal Reserve documents 18 page

On Friday evening I attended, with other conference participants, a small dinner at the Jackson Hole home of Jim Wolfensohn, a former president of the World Bank and business partner of Paul Volcker’s. We talked about the events of the past year. Wolfensohn asked the gathering whether what we were experiencing would be a chapter or a footnote in the economics textbooks of the future. Most of the attendees thought it would be a footnote. I declined to answer, but I was still hoping against hope for the footnote.

SEPTEMBER 1 WAS Labor Day, but, given the urgency of the situation at the GSEs, our work went on. Representatives of the Treasury, Fed, and FHFA met all three days of the long weekend, in a large conference room across from the Treasury secretary’s third-floor office. Dress was casual and staff came and went. Besides me, the Fed’s representatives included Don Kohn, Kevin Warsh, Scott Alvarez, and

Tim Clark, the bank supervisor who was leading the Fed’s review of Fannie’s and Freddie’s books. A war room at Treasury was appropriate—after all, Congress had given Paulson the bazooka. As

Hank moved from one issue to another, pressing for solutions or more analysis, I could see why he had been an effective CEO. Like a general planning a surprise attack in hostile territory—not a bad metaphor for what we were discussing—Hank wanted to be sure that we had thought through every possibility. We believed that taking control of Fannie and Freddie was the only way to stabilize them. Doing so in a weekend, without advance warning or leaks, was going to be difficult enough. But Hank also asked the Treasury and Fed staff to think through how to keep the two companies operating effectively after the takeover. Lawyers briefed us about the alternatives for taking control, and we debated the structure of the guarantees that the Treasury would offer for GSE debt and GSE-sponsored MBS. Another concern: What if the GSEs decided to fight the takeover? If they resisted, what damage could a period of legal uncertainty do? What could we do to make sure the companies retained key employees?

The spillover effects of a takeover were also hard to anticipate. For example, many small banks held significant amounts of GSE stock, and I worried that a takeover that further reduced the value of that stock might cause community bank failures. I asked our staff to try to estimate community banks’ exposure to the GSEs, but with limited data their answers involved a lot of guesswork.

Planning continued through the week, with the Treasury, Fed, and FHFA teams reconvening at Treasury at 8:00 a.m. Thursday, September 4. Tim Clark’s team of examiners once more confirmed that Fannie and Freddie were effectively insolvent. The OCC and the outside consultants from Morgan Stanley concurred. The time had come to fire the bazooka. Hank, Jim Lockhart, and I agreed to set up a meeting with the CEOs and senior executives of Fannie and Freddie, rehearsing what each of us would say.

The showdown came the next day in an unprepossessing conference room at the FHFA headquarters, less than a block from the White House and the Treasury. We had avoided leaks about the meeting until

Wall Street Journal reporter Damian Paletta spotted me entering FHFA by the front door. He flashed thenews on the Journal’s financial wire. Daniel Mudd and Dick Syron were visibly shocked when Paulson told them that the U.S. government was going to put the two companies into conservatorship.

Conservatorship, rather than receivership, would ensure that the companies would continue to perform their vital role in supporting housing. Conservatorship also protected the holders of Fannie’s and Freddie’s debt and MBS, which would be necessary to avoid creating a panic in global financial markets. The Treasury would inject capital into the companies as needed to keep them solvent.

I spoke next. I emphasized the gravity of the economic situation and the national interest in stabilizing housing and financial markets. Markets were questioning the companies’ fundamental solvency, and for good reason, I said. We needed to remove the uncertainty about Fannie and Freddie to avoid even greater financial volatility. At the same time, for the sake of the U.S. housing market, the companies had to remain going concerns. Lockhart followed, discussing the details of his findings and the steps his agency would be taking. Paulson told the CEOs to explain to their boards that one way or the other the companies would

be taken over. Hank must have been convincing, because Mudd and Syron didn’t resist.

We had decided to replace them. Hank’s lifetime of contacts in the financial services industry came in handy here. By Sunday we were ready to announce that Mudd would be succeeded at Fannie by Herb Allison, a veteran of Merrill Lynch who at that time was heading the TIAA-CREF pension fund. Syron’s replacement, David Moffett, came from the management ranks of the Minneapolis-based U.S. Bancorp. Hank characterized the jobs to Allison and Moffett as opportunities for public service.

After the initial shock, the takeover was well received in most circles, including by many in Congress. Investors, including foreign central banks, were relieved that the U.S. government’s implicit guarantee of agency debt and agency-guaranteed MBS had been made explicit. The Treasury also announced that it would be purchasing modest amounts of MBS and that it would provide a liquidity backstop for the GSEs, eliminating the need for the line of credit extended by the Fed. (We would keep the line in place anyway, as a precaution, although it would never be used.) Investors became more comfortable holding GSE-backed MBS and mortgage rates fell by a half percentage point over the next two weeks. Fannie and Freddie stock prices, however, fell close to zero. As we expected, many smaller banks were among these stockholders, and we had to provide assurances that their supervisors would work with them to ensure that they had adequate capital.

Former Fed chairman Paul Volcker aptly summarized the state of play in an interview around that time. “It is the most complicated financial crisis I have ever experienced, and I have experienced a few,” he said. Volcker had dealt with financial dustups on his watch, including the debt crisis in developing countries in 1982 and, in 1984, the largest-ever U.S. bank failure, of Continental Illinois, a record that would stand only a little while longer.

* The Treasury helped us solve this dilemma to some extent, by raising money in debt markets and depositing the proceeds with the Fed. Its Supplementary Financing Program (SFP) pulled cash out of the private sector and allowed us to finance our emergency lending without increasing bank reserves. However, the SFP varied in size, and had to be drawn down when the government approached its statutory debt limit. Thus, it was not a reliable solution to our problem. And, as officials of an independent central bank, we didn’t like to be dependent on Treasury’s help in setting monetary policy.

CHAPTER 12

Lehman: The Dam Breaks

Of all the firms that came to grief in 2007 and 2008, none was more controversial or emblematic of the crisis than Lehman Brothers—a storied investment bank with roots extending to the pre–Civil War South.

Lehman was founded in 1850 as a cotton brokerage by three Jewish brothers (Henry, Emanuel, and Mayer) who had emigrated from Bavaria to Montgomery, Alabama. The brothers relocated their headquarters in 1868 to New York City, where they helped found the New York Cotton Exchange. In the early 1900s, Lehman shifted to investment banking, arranging the financing needed by growing companies in the nation’s rising industries, from aviation to motion pictures. The Lehman family became important in New York politics, with Herbert Lehman, Mayer’s son, serving as lieutenant governor of New York during Franklin D. Roosevelt’s governorship, then succeeding to the governorship when FDR became president in 1933.

The Lehman franchise appeared to have come to an end in 1984 when American Express acquired it and merged the firm with its retail brokerage, Shearson, to create Shearson Lehman. But after years of backbiting between Lehman executives and the parent company, Amex restored the original Lehman Brothers name to the division in 1990 and spun it off as an independent company in 1994.

The responsibility for recapturing Lehman’s past luster fell to its new CEO, Dick Fuld, who had joined Lehman Brothers as a commercial paper trader in 1969. An intensely competitive, wiry man with deep-set eyes and a volatile temperament, Richard Fuld Jr. (nickname: the Gorilla) projected the opposite of the traditional gentility of investment bankers. But he accomplished what he set out to do, multiplying the firm’s profits many times over. After the 9/11 attacks severely damaged the firm’s headquarters at 3 World Financial Center, he purchased a midtown Manhattan building from archrival Morgan Stanley, and

within a month Lehman was up and running again. In 2006, a Fortune magazine article lauded Lehman’s “greatest run ever” over the previous decade. “So complete has Fuld’s makeover of Lehman been that he is more like a founder than a CEO,” the magazine said. By 2008, Fuld was the longest-serving CEO of a major Wall Street firm.

Fuld’s commitment to his firm was evident in every discussion or encounter I had with him. He saw the firm’s success as a personal validation. In the same vein, every short sale of Lehman stock or investor question about the quality of Lehman’s assets stung him like a personal affront. (Effectively, a short sale is a bet that the value of a stock will go down—the opposite of purchasing a stock, which is a bet that the value will go up.) But, as of the summer of 2008, Fuld’s “greatest run ever” was coming to an end.

Lehman Brothers had two problems. First, like Bear Stearns, the firm depended heavily on short-term, uninsured repo funding, though it did have an important advantage over Bear: access to Federal Reserve loans through the Primary Dealer Credit Facility, which had been created the weekend JPMorgan agreed to acquire Bear. The PDCF reduced Lehman’s vulnerability to unexpected cash outflows. However, like the discount window for commercial banks, the PDCF carried some stigma (no firm wanted to admit that it needed to borrow from it). Lehman borrowed seven times from the PDCF in March and April, in amounts as high as $2.7 billion, but then stayed away.

Lehman’s second, more fundamental problem was the quality of its $639 billion in assets as of the end of May. Fuld and his lieutenants had been aggressive even by pre-crisis Wall Street standards, propelling the company into commercial real estate, leveraged lending (lending to already indebted firms to finance takeovers and other speculative activity), and private-label mortgage-backed securities. In the process, they had blown through the company’s established guidelines for controlling risk. Substantial profits and executive bonuses followed. But, as real estate crashed, the values of many of these assets plunged. Other companies suffered losses, of course, but Lehman’s losses were particularly severe, and its reservoirs of capital and cash were smaller than most. Moreover, Fuld and his team seemed in denial about how badly their bets had gone wrong. Compared to many of its peers, Lehman was slow to mark down the values it assigned to questionable real estate assets. Egged on by critics like David Einhorn, the contrarian manager of the hedge fund Greenlight Capital, investors and rival firms were growing increasingly skeptical of Lehman’s judgment of the value of its holdings.

The SEC supervised Lehman’s principal subsidiaries, which were broker-dealers—firms that buy and sell securities. U.S. law permitted Lehman’s parent company, Lehman Brothers Holdings, to operate unsupervised—by the SEC or any other agency. However, to meet requirements imposed by European authorities, the Lehman parent voluntarily agreed to supervision under the SEC’s Consolidated Supervised Entities program. Not surprisingly, this voluntary arrangement was less strict than one required by law might have been.

Despite a sincere effort, the SEC was not well suited to supervising the investment banks. It was, and remains, primarily an enforcement agency. SEC lawyers enforce laws, like those prohibiting broker-

dealers from misappropriating funds from customer accounts or requiring truthful disclosures about securities products, and punish violations. They are not there to ensure that firms are well run. The SEC was not, in other words, a supervisory agency like the Fed or the Office of the Comptroller of the Currency, whose examiners focus on the overall safety of the banks they oversee in addition to their compliance with consumer protection rules.*

Although the Fed was not responsible for supervising investment banks and in fact lacked the authority to do so, we did gain some access to Lehman after the Bear Stearns rescue. With the establishment of the PDCF, we had leverage to request information from Lehman because it might want to borrow from us. Moreover, the SEC was looking to the Fed for help. After JPMorgan Chase bought Bear, the New York Fed staff conferred frequently with the SEC and Lehman—up to three times per day. We would eventually send a small number of bank supervisors to Lehman and the other remaining investment banks. At first, the relationship between the agencies was bumpy. Fed supervisors were reluctant to share what they learned with the SEC division in charge of enforcing securities laws out of concern that doing so would make the investment banks unwilling to cooperate. Chris Cox and I negotiated a memorandum of understanding, signed on July 7, that laid out ground rules, and the coordination between the agencies improved.

Without doubt, Lehman needed capital. How much was difficult to determine. The company and its critics profoundly disagreed on the value of its complex investments. Investors and accounting standard setters had embraced more widespread application of the mark-to-market approach, under which valuations are determined by prices on the open market. But for some assets, such as individual loans to particular companies, an active market might not exist; or if it did, it might have very small numbers of buyers and sellers. Prices in such small markets are less reliable, especially in a panic. Often, valuations came down to whose assumptions you preferred to believe.

Valuation controversies notwithstanding, that investors lacked confidence in Lehman was not in dispute, and in the end that was what mattered most. Tim Geithner and, especially, Hank Paulson had been concerned about Lehman’s viability since well before Bear Stearns, and Hank had been pressing Fuld to raise more capital for at least a year. After Bear, and in light of a sequence of downgrades of Lehman’s credit rating, the Fed and the Treasury ratcheted up pressure on Fuld, telling him that he needed either to raise new capital or find a partner willing to buy a large stake in his company. Tim was the Fed’s principal contact with Fuld. Geithner and Fuld spoke on the phone some fifty times between March and September, and Fuld kept Tim informed about the leads he was pursuing. Hank—who often made dozens of calls in a day—also spoke often with Fuld. Based on their conversations, both Hank and Tim believed Fuld didn’t have a realistic view of what his firm was worth even as he actively considered many options.

If Lehman had been a midsize commercial bank, forcing Fuld to raise more capital would have been straightforward: Either the company met the supervisors’ expectations or the FDIC would have taken it over and paid off depositors as necessary. But neither the Fed nor the FDIC had the authority to take over

Lehman, nor could the FDIC deposit insurance fund be used to cover any losses. Legally, the government’s only alternative, if Lehman couldn’t find new capital, would have been trying to force the firm into bankruptcy. But that was a nuclear option. Because of Lehman’s size, its extensive interconnections with so many financial firms and markets, and the already shaky state of investor confidence, we knew that forcing it into bankruptcy could unleash financial chaos.

On Monday, June 9, Lehman had announced a $2.8 billion second-quarter loss (its first since splitting from American Express in 1994) but also said that it planned to raise $6 billion in capital by selling new stock. Don Kohn told me that he thought the new capital “should stabilize the situation, at least for a time.” “But,” he warned, “there are deeper problems.” The large surprise loss had undermined Lehman’s credibility and raised questions about what else it might be hiding. Don said a “hedge fund type” had told him a Wall Street consensus had formed that Lehman’s days were numbered. “The question is when and how they go out of business, not whether,” Don wrote. Once again I worried about self-fulfilling prophecies: If concerns about Lehman’s viability became sufficiently widespread, other firms would stop doing business with it and make recovery impossible.

We wanted Lehman to have enough cash and easily sellable liquid assets to fund itself for a while if it lost access to the repo market. In May, the New York Fed and the SEC had worked together to evaluate the ability of the remaining four independent investment banks (Goldman Sachs, Morgan Stanley, Merrill Lynch, and Lehman) to withstand a run. We subjected them to “stress tests” under two hypothetical scenarios to see if they had enough liquidity to survive in circumstances like those Bear Stearns had faced in March. One of the two scenarios was dubbed “Bear” internally—it tried to capture the actual stresses faced by Bear Stearns. The second, milder scenario was dubbed “Bear Light.” With the Bear Stearns experience in mind, we assumed that repo lenders could run, even though repo borrowing is collateralized.

Although two of the investment banks (Morgan Stanley and Goldman) had enough liquid assets to get through Bear Light, none passed the Bear test. We pushed the companies to fix the problem, telling Lehman in particular that it needed at least $15 billion more in liquid assets. Lehman reported an increase in its liquidity by some $20 billion by the end of July, and it sold some of its real estate. As it turned out, however, not all the extra liquidity was really available for an emergency; much of it had already been committed as collateral. And, as credit losses mounted, Lehman’s solvency and longer-term viability remained in doubt.

In late August, Fuld floated the idea of dividing Lehman into two pieces: a “good bank,” which would retain the company’s best assets and its operating businesses, and a “bad bank,” which would hold the company’s troubled commercial mortgages and other real estate assets. Within Lehman, the two units were referred to as “Cleanco” and “Spinco.” Lehman would put capital into the bad bank and try to raise additional financing for both parts of the company. Paulson immediately made clear that the government had no authority to put money into the bad bank, as Fuld proposed. The good bank–bad bank strategy can

be successful under the right conditions. The good bank—shorn of its questionable assets—may be able to raise new capital, while the bad bank can be financed by speculative investors at high interest rates and wound down, with assets being sold off over time. Fuld said that he hoped to divest Lehman’s bad assets and make up the losses by selling one of the company’s most valuable subsidiaries, its asset management unit, Neuberger Berman. Some thought it could fetch $7 billion to $8 billion. However, the plan, even if it ultimately proved workable, would take months to complete. It was time Fuld didn’t have.

Concurrent with Fuld’s newly offered plan, the state-owned Korea Development Bank had proposed acquiring a significant stake in Lehman. Fuld had been talking to the Koreans for several months. Other possible suitors included China’s CITIC Securities, two Middle Eastern sovereign wealth funds, the MetLife insurance company, and the British bank HSBC. On September 8, criticism of the deal by the main Korean financial regulator spurred the Korea Development Bank to retract its proposal, and none of the other possible deals came to fruition. Fuld also approached investor Warren Buffett, with no success. Lehman’s stock price continued to drop (the news from Korea alone caused it to fall from $14.15 per share to $7.79 per share in one day), making raising new capital even more difficult.

With would-be investors shunning Lehman, the Fed and the Treasury in early September focused on finding another company to take it over. Paulson had been in touch with Bank of America CEO Ken Lewis, who was known to want an investment bank. Lewis played it close to the vest. He might be interested in Lehman, but it would depend on the company’s condition and, possibly, on the government’s willingness to help. Lewis raised another concern. Although he had not been pressured by the government to acquire Countrywide, he believed that in doing so he had contributed to the stability of the broader financial system. As I would hear from our supervisors, Lewis was accordingly upset that—contrary to what he believed were commitments from the Fed—the Richmond Fed, his immediate supervisor, was pressing his bank to raise more capital. He wanted to know whether, given the criticism, the Fed would let him buy Lehman.

Board general counsel Scott Alvarez and I investigated Lewis’s complaint. The concerns expressed by the Richmond Fed seemed reasonable. Bank of America had recently raised $20 billion in capital, but its acquisition of Countrywide exposed it to potentially large mortgage losses. The Richmond Fed had a good case for pushing Bank of America to add more capital, for example, by retaining more of its earnings and paying out less to shareholders. Importantly, though, based on the information available, Richmond supervisors did not rule out another acquisition, if it made sense for Bank of America. That was good news. It meant that one of our best options for avoiding the collapse of Lehman remained viable.

Fuld’s frenetic attempts to strengthen his firm were not bearing fruit and the endgame looked to be approaching. On September 9, Board economist Patrick Parkinson told me that on September 18 Lehman would disclose another substantial loss—$3.9 billion for the third quarter. He added that Geithner and Cox planned to tell Fuld that, if he didn’t raise capital, he would have to consider bankruptcy. Their goal

was to shock Fuld into action. We were also concerned about the company’s funding, including its reliance on about $200 billion from the tri-party repo market. Eric Rosengren, who had good contacts in the mutual fund industry, reported that key lenders were already pulling back from Lehman. “They would move more quickly,” Eric wrote, “but they do not want to be blamed for triggering an event.” Meanwhile, JPMorgan, Lehman’s clearing bank for repo funding, demanded an additional $5 billion in collateral.

Wednesday, September 10, began with more dour conference calls and meetings. Lehman had no promising leads for raising capital. Rosengren reported that if the credit agencies downgraded Lehman, some lenders were saying that they would have to pull away completely. It seemed increasingly obvious that finding a purchaser—or at least a major investor willing to buy a large part of the company—might be the only way to avoid Lehman’s collapse. No new buyers had surfaced. Ken Lewis and Bank of America still seemed the best bet.

Unfortunately, given all that was going on, I had a longstanding commitment to visit the St. Louis Fed. Normally, I found Reserve Bank visits—and the chance to meet local board members, employees, and business leaders—valuable. But with Lehman unresolved and a regular FOMC meeting coming up the next week, I regretted that I had agreed to this one. That evening I attended a dinner for past and present members of the St. Louis Fed board. Early the next morning, in my hotel room and not yet dressed, I received a call from Hank Paulson. He was worried that Lewis was getting cold feet. Would I call him?

I reached Lewis and we talked for about twenty minutes. I urged him to continue with his evaluation of Lehman’s books and its fit with Bank of America. I reiterated a message already sent by the supervisory staff—his bank needed to strengthen its capital over time, but we did not think that Bank of America’s current capital position would preclude its acquisition of Lehman, provided the deal made business sense. Lewis agreed to continue to look at Lehman and bring a team to New York. I felt encouraged. His reaction to the financial storm was to look for bargains rather than to hunker down.

Bespectacled, quiet, and reserved, Lewis had nevertheless maintained the hard-charging style of his predecessor, Hugh McColl. Through a series of aggressive acquisitions, in Florida, Texas, and elsewhere in the South, McColl—a former marine from South Carolina—had transformed NCNB (North Carolina National Bank) into a regional powerhouse called NationsBank. In 1998, four years after Congress substantially reduced restrictions on banks branching across state lines, McColl’s bank became the first with coast-to-coast operations when it acquired Bank of America, which had been founded in 1904 in San Francisco by the legendary A. P. Giannini. Though NationsBank was the acquirer, it took the better-known name of the acquired company. After McColl retired in 2001, the Mississippi-born Lewis took over. He had joined NCNB in 1969 as a credit analyst, after putting himself through Georgia State University. As CEO, he focused mostly on consolidating the acquisitions made under McColl’s leadership, although his acquisition of FleetBoston in 2004 gave Bank of America a foothold in New England.

I FLEW BACK to Washington on Thursday, September 11. The FOMC meeting was scheduled for Tuesday, September 16, and, with my focus on Lehman, I had not prepared as much as usual. Don offered to help me. Between the two of us, on Friday we called most of the Reserve Bank presidents to discuss policy choices, and I also visited with the other Board members.

The economic outlook appeared little changed from August. The combination of rising inflation and a slowing economy continued to pose the classic central banker’s dilemma. We could not simultaneously damp inflation with higher interest rates and stimulate growth with lower interest rates. Consumer prices were up a troubling 5.4 percent from a year earlier, reflecting both high commodity prices and more broad-based pressures. But at the same time, after a surprisingly strong spring, the economy was clearly weakening. The unemployment rate had jumped sharply in August—to 6.1 percent from 5.7 percent the month before.

The rise in inflation had stirred up the FOMC hawks. Before the August 5 meeting, the private-sector boards of three Reserve Banks—Kansas City, Dallas, and Chicago—had recommended raising interest rates. Generally, the private-sector boards are heavily influenced by the views of the local Reserve Bank president, so these “recommendations” signaled, none too subtly, the positions of at least three FOMC participants. The hawks were backed by the usual suspects, including the Wall Street Journal editorial page, which thundered against our “reckless easing.” The doves had been pushing back. They argued in public remarks that financial turmoil was diluting the effect of monetary medicine and that a stronger dose was needed. Banks were tightening credit standards, they pointed out, and important interest rates like the rate on car loans had not fallen by as much as the Federal Reserve’s target rate.

From my consultations, I concluded that the center of the Committee favored holding policy steady, at least for now. I shared that view and was working to prevent a victory for the hawks. The wait-and-see approach appeared to have been winning the day abroad as well. The European Central Bank, after its rate increase in July, had held steady in August. The Bank of Canada and the Bank of England had also made no changes to their key interest rates.

BY FRIDAY, SEPTEMBER 12, the media were widely reporting the government’s efforts to find a solution for Lehman. Fuld continued to talk about his good bank–bad bank plan and the possibility of selling Neuberger Berman, but the markets weren’t listening. Lehman’s stock had sold for $4.22 at the end of trading on Thursday, 7 percent of its value in February. Worse, a broad-based run appeared to be under way. So many customers and counterparties were demanding cash or additional collateral that the firm was unable to process the requests.

Date: 2016-04-22; view: 754