In FED We Trust, page 13
A more apt description might have been “originate and hide.” Banks hadn’t distributed nearly as much risk as even sophisticated observers thought. The bad loans — and massive losses — would end up with the banks, eroding their capital cushions to the point where, eventually, their only option for survival was a government bailout.
“All of a sudden,” Kohn said months later, “it became very clear the risk had not been distributed. So all I had said at Jackson Hole about risks being distributed and people being safer and people knowing what they had and people could choose and diversify and all that — it turned out to be not entirely true.”
Citigroup had pioneered entities called “structured investment vehicles,” or SIVs. In essence, mortgage loans were sliced into pieces, with some sold and others kept in these stand-alone units. The SIVs borrowed money by selling short-term IOUs on the market, making them vulnerable to a change in investor appetite for short-term lending. And SIV loans frequently were not shown on the banks’ books. A bank has to set aside capital — a cushion to absorb losses — for every loan it makes and every bond it buys. By parking the loans and securities in SIVs off the banks’ balance sheets, Citibank and other banks that used SIVs didn’t have to set aside capital to absorb any losses. That made the potential profits far greater than if the loans had been on the banks’ books. But it also meant there was no capital cushion to absorb losses if the banks ended up taking back the losses, either because they had legal promises to the SIVs or felt maintaining reputations required them to bail out the SIVs. “We didn’t recognize how much the stuff would flow back onto the bank balance sheets,” Kohn said.
In 2006, Citibank’s off — balance sheet assets amounted to $2.1 trillion; its on — balance sheet assets were $1.8 trillion. Not only were these enormous loans hidden, but several top Fed staffers confessed later that they hadn’t even heard the term “SIV” until the end of July. Neither had some senior Fed officials — even though they were charged with being guardians of the financial system. In fact, that was typical. An astounding array of derivative products had exploded across the marketplace over the past few years. Even market sophisticates faced a steep learning curve to keep up with what was happening, and that included Citigroup’s own chief executive, Chuck Prince.
Dubbed “Prince of the Citi” by the financial press when his bank was flying high, Prince was a lawyer who had taken over the big bank in 2003 when Sandy Weill, the financial entrepreneur, retired. Prince famously dismissed worries that his bank and others were counting unwisely on cheap and plentiful credit to make ever bigger and riskier loans. “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing,” he told the Financial Times in early July 2007. It was, actually, a profound observation: a banker who didn’t dance, who didn’t make ever more risky loans, would find his bank’s market share falling and near-term profits less impressive than his competitors’. Prince was one of several Wall Street chief executives who, it turned out, didn’t understand the risks their own institutions were taking or who were powerless to stop them. Citi, it would become clear, was not only too big to fail, it was too big to manage. (By November 2007, Prince would be gone.)
Ben Bernanke soon would discover what happens when the music stops, but he had good reason to believe that his team had the experience, smarts, and tools to manage the situation.
Chapter 6
THE FOUR MUSKETEERS:
BERNANKE’S BRAIN TRUST
By the summer of 2007, the Fed was stocked with veterans of market crises: the stock market crash of 1987, the savings and loan scandal of the late 1980s and early 1990s, the commercial banking and real estate woes of the early 1990s, the Asian financial crisis of the late 1990s, the bursting of the tech-stock bubble in 2000, and the September 11 terrorist attacks. The conventional wisdom was that crises were unavoidable despite all the best efforts at prevention. The countervailing comfort was that cleverly conceived and targeted responses by the Fed and Treasury — even if flawed in detail — could limit the economic damage from even the most frightening shocks.
The thinking wasn’t as excessively self-confident as it had been back in July 1990 when Frederic Mishkin, then a Columbia University professor, later a Fed governor, declared that: “Since 1945 … in no instance has there been a financial crisis that has had serious adverse consequences for the aggregate economy.” But within the Fed, self-confidence still ran high. No crisis was unmanageable if you had the brainpower on hand to deal with it, and the Fed had plenty of brains.
Assembled with Bernanke to deal with the emerging grim economic reality were vice chairman Don Kohn, sixty-six, the levelheaded economist who had joined the Fed staff when Richard Nixon was president; Kevin Warsh, thirty-eight, the well-connected Gen-X investment banker who had come to the Fed from the White House shortly after Bernanke had; and Tim Geithner, forty-seven, who was president of the Federal Reserve Bank of New York and the baby-boomer protégé of Treasury secretaries Bob Rubin and Larry Summers.
The composition of this core group was born from background, personality, and legislative strictures. Under the Government in the Sunshine Act, no more than three Fed governors can meet to consider action without formal notice. Bernanke, Kohn, and Warsh made three; Geithner, even though he was president of the most powerful regional Fed bank, didn’t count because he wasn’t a member of the Fed board of governors. As events unfolded rapidly, the Fed needed maximum operational flexibility for the daily barrage of meetings and conference calls. This meant that other governors, including Bernanke’s friend and like-minded academic Mishkin, were frequently left on the sidelines.
Bernanke, Kohn, Warsh, and Geithner became known to some inside the Fed as “the Four Musketeers” — the group that would call every significant play during the Great Panic at the Fed until Geithner left to serve as Obama’s Treasury secretary.
KOHN: GREENSPAN’S CONSIGLIERE
Don Kohn began working at the Federal Reserve Bank of Kansas City even before finishing his Ph.D. at the University of Michigan and had never worked outside the Fed. Kohn moved to the Fed’s Washington headquarters in 1975, climbing the staff ladder under Chairman Paul Volcker and becoming one of Alan Greenspan’s closest advisers. Eventually he inherited one of the three princedoms in the Fed staff hierarchy — director of monetary affairs. In that job, he prepared a series of options on interest rates before each FOMC meeting and discussed them there. Laurence Meyer, a former Fed governor, said Kohn was “always calm and thoughtful, and perhaps the staff member the FOMC members relied upon most frequently for guidance at meetings.”
Greenspan relied on him, too, particularly in fashioning the market-moving words he used to describe the Fed’s thinking and intentions. During the 1998 Asian financial crisis, Kohn was at Greenspan’s side as the chairman wrote a sentence into a speech to signal that the Fed would cut interest rates even if the U.S. economy didn’t appear to be in imminent danger: “It is just not credible that the United States can remain an oasis of prosperity unaffected by a world that is experiencing greatly increased stress.” The wording was meant and received as a signal that the Fed would cut its interest rates even though the U.S. economy wasn’t then feeling much pain from the Asian crisis. The power of the Fed — and its chairman — is such that a sentence like that can lead traders and investors with multibillion-dollar hands to change their bets.
Kohn kept a loose-leaf binder by his desk that held every statement the FOMC had made since it began making public pronouncements in 1994, nearly all of which he helped write. After fourteen years in the grueling monetary-affairs post, Kohn took a step away from the center ring in 2001 to serve as an “adviser,” a job created for him, to the Federal Reserve Board. That’s what he was doing in 2002 when the White House personnel office called to inquire about his interest in serving as a Fed governor. His first reaction was to walk down the quiet hallway to Greenspan’s office. Greenspan had been tipped off by the White House but acted surprised — and pleased. Kohn aced his interview with White House personnel chief Clay Johnson and began preparing for a grilling by the president. He rehearsed with his wife at home and then tried out his pitch on Greenspan. The chairman stopped him. “You don’t have to prove anything. Just don’t say anything stupid or bad, and it’s yours,” Greenspan told him.
A few days later in the Oval Office, the president asked Kohn if he thought there were limits to economic growth. “I thought, ‘Oh man, if I tell him that there are limits to how fast the economy grows, then he probably doesn’t like to hear that.’ So I danced around his question,” Kohn recalled. Bush noticed and pressed for an answer. SO, Kohn said, “I gave him the honest answer: ‘Yeah, I think there’s a limit to how fast the economy grows … and if you push past that, you’re going to get inflation.” If the president didn’t like the answer, he didn’t let on. “You’ll do fine,” he told Kohn.
For decades, Kohn’s most prominent moments were showing up on CNBC, sitting behind Greenspan while the chairman testified before Congress. After becoming a governor, his public profile rose significantly. As Greenspan’s retirement neared, The Economist endorsed Kohn to be the Great Man’s successor. Instead, Bush appointed Kohn to be Bernanke’s vice chairman in the spring of 2006, passing over Mishkin, who was named a plain old governor.
Kohn was the institutional memory in the Bernanke brain trust, the one man in the room who could plausibly say: “This is what Greenspan would have done in this situation.” He was often the one to find the flaws in Bernanke’s latest bit of creative financial engineering.
Kohn had been among Bernanke’s intellectual adversaries when both were mere governors. Bernanke thought Greenspan’s approach to monetary policy relied too much on the chairman’s discretion and not nearly enough on well-explained rules. Along with Geithner, Kohn long had been on the other side, defending Greenspan’s approach. Before Bernanke ascended to the throne, Kohn took the lead in making the public case against his inflation-targeting proposal, squaring off against Bernanke face-to-face at a St. Louis Federal Reserve Bank forum on the topic in 2004. Aware of skepticism about inflation targeting both inside the Fed and on Capitol Hill, Bernanke knew he couldn’t make progress without Kohn’s support. So Bernanke appointed Kohn to head a subcommittee to examine “communications” — a euphemism for “inflation targeting.” Bernanke knew that Kohn commanded enormous respect and affection among the Fed staff and policy makers, and he knew that Kohn was unfailingly loyal to the chairman, whoever it happened to be.
By August 2007, Kohn had sold his house in northern Virginia and was planning to spend more time at his weekend place in Annapolis, Maryland. Meanwhile, he and his wife were spending weeknights in a basement apartment of their son’s Takoma Park, Maryland, house. Before the work hours demanded by the credit crisis became overwhelming, Kohn often rode his bicycle to work, parking it in the space in the Fed garage reserved for governors’ cars. He also had a thing for running up and down the stairs at the Fed instead of taking the elevator.
His low-key personality, experience, and credibility made Kohn a trusted mediator — sometimes among members of the Fed board who felt excluded from the inner circle; sometimes between Geithner and Sheila Bair, the chairman of the Federal Deposit Insurance Corporation, who was reluctant to expose the deposit-insurance fund to potential losses even when the entire economy was at risk.
WARSH: THE NETWORKER
Kevin Warsh was in many ways Ben Bernanke’s opposite.
Bernanke was cerebral, introverted, an alpha in academic networks such as the National Bureau of Economic Research, but an outsider on Wall Street and in Washington. Warsh was outgoing and practical, maintained a rich network of Wall Street contacts, and moved easily among conservative Republicans in the Bush White House and Congress.
Warsh, whose father made his living manufacturing school uniforms, had been a high school tennis star in upstate New York. While he was still a Stanford undergraduate, Warsh finagled his way into the inner circle of West Coast Republican economists at Stanford’s Hoover Institution. A math geek, he got a job helping Hoover economists build computer models. One of them, John Cogan, a veteran of the Reagan White House, recalled Warsh asking for help in bringing conservative icon William F. Buckley to campus.
Buckley came, spoke to the student body, and predictably drew pickets. At a dinner for about thirty people before the speech, Cogan asked Warsh to make a few remarks. When he finished, Buckley leaned over to Cogan and said, “This is the most impressive college senior I’ve come across in years.” It was typical Warsh, the agile networker successfully impressing those senior to him in years and experience.
Warsh majored in public policy, graduated with his class in 1992, and contemplated staying on at Stanford to pursue a Ph.D. in economics, but his father deemed that a waste of time and encouraged Warsh to do something else: Harvard Law School. From there, Warsh worked seven years as a mergers and acquisitions investment banker at Morgan Stanley.
In 2002, Warsh married his Stanford classmate Jane Lauder, an heir to the Estee Lauder cosmetics fortune and the daughter of reliable Republican campaign contributor Ronald Lauder. The marriage made Warsh wealthier than all his fellow Fed governors combined. The couple has a penthouse duplex in the trendy NoLita neighborhood of lower Manhattan for which she paid $12.6 million in 2005 as well as a town house in Georgetown for which they paid $2.3 million after Warsh was appointed to the Fed. (Ethics lawyers advised him to take a mortgage from the White House Federal Credit Union to avoid any hint of favoritism from a lender overseen by the Fed. He did promise to avoid anything involving JPMorgan Chase because his wife had money there. Ethics lawyers later waived that restriction so he could deal with JPMorgan Chase during the Great Panic.)
Warsh’s connections to the Hoover mafia led to a job on the White House staff in 2002 just as Bush was junking his initial economic team. Warsh ended up working for Stephen Friedman, the former Goldman Sachs chief executive, on corporate finance and capital markets issues and on the administration’s efforts to rein in Fannie Mae and Freddie Mac, the government-sponsored mortgage giants.
When Bernanke arrived at the White House in 2005, he and Warsh were often at the same meetings — Bernanke talking about the economy, Warsh about the markets. Warsh also helped prepare Bernanke for his confirmation hearings, and in a sign of his unusual agility at the Washington game, he maneuvered to get himself nominated as a Fed governor, then won confirmation despite being the youngest appointee in Fed history.
Arriving at the Fed less than a month after Bernanke became chairman, Warsh established himself as the chairman’s protector in Republican circles and Bernanke’s bridge to Wall Street chief executives. When CEOs didn’t feel comfortable calling Bernanke directly, they would call Warsh and know their message had been delivered. Bernanke’s reliance on Warsh for advice on Republican and Wall Street politics became enshrined in the chairman’s frequent query to his staff: “Have you run it by Warsh?”
GEITHNER: DIPLOMAT WITH AN ATTITUDE
The fourth Musketeer, Tim Geithner, was about a decade older than Warsh but was a lithe marathoner and tennis player who looked younger than his forty-seven years. His good looks later earned him a spot on People magazine’s 100 Most Beautiful People list. His youthful appearance not only made him less threatening to big-ego superiors but, before he’d achieved his current prominence, led some interlocutors to underestimate him. However, it proved to be a major liability when he became Treasury secretary.
As a result of his father’s work with the Ford Foundation, Geithner spent most of his childhood overseas. He returned to the United States to attend Dartmouth College and graduate school at Johns Hopkins University. Then Geithner had a stint at Henry Kissinger’s consulting firm before joining the Treasury in 1988 as a career bureaucrat. For a time, he was the Treasury’s attaché in Tokyo, but after he came back to Washington, Rubin and Summers promoted him rapidly. Geithner entered the Clinton administration as undersecretary for international affairs, the position Summers had started in 1993 (and one that comes with one of the best offices at the Treasury, a room restored to look as it did in 1865, when Andrew Johnson used it while waiting for Abraham Lincoln’s widow to vacate the White House). Geithner was at the epicenter of the U.S. government’s response to the Mexican and Asian financial crises of the 1990s. The experience had taught him a lot about crisis management and an enduring lesson: smart people solve crises one at a time and worry about dealing with unintended consequences tomorrow. It seemed to work in the past but, with much higher stakes, didn’t prove as successful a strategy in the Great Panic.
Geithner wasn’t on anyone’s short list in 2003 when the New York Fed was looking for a successor to retiring William McDonough. The New York Fed’s search committee first considered more likely candidates: Peter Fisher, a former top New York Fed staffer who had coordinated the rescue of the Long Term Capital Management hedge fund, and then done a stint at the U.S. Treasury in the early George W. Bush years; Stanley Fischer, the former MIT professor who had been Bernanke’s adviser and had gone to the World Bank and the number two job at the International Monetary Fund; and John Taylor, a Stanford economist whose expertise in monetary policy earned him an international reputation. But Peter Fisher had rubbed some Fed insiders the wrong way. Taylor’s time as the Bush Treasury’s top international hand suggested he was a better professor than manager. And Stan Fischer had just taken a well-paid post at Citigroup.
