In FED We Trust, page 14
Bob Rubin had tried to lure Geithner to join Stan Fischer and other veterans of the Rubin Treasury at Citigroup, but without success. Geithner had taken a job at the IMF instead — where, to his later embarrassment, he failed to pay all the U.S. taxes he owed. Still, Rubin remained an admirer, and as others fell off the short list, he offered Geithner’s name to Pete Peterson, the cofounder of the Blackstone private equity group and chairman of the New York Fed Board. In response, Paul Volcker, who was on an advisory committee for the search, asked, not completely seriously: “Who’s Geithner?”
When Peterson reached Geithner in London, Geithner’s first reaction was, “It isn’t plausible.” The job, he said, was usually for someone at a later stage of life. But he discovered that Peterson had done his homework and that Greenspan had endorsed the idea. He respected Geithner but also knew Geithner wouldn’t challenge him. Not wanting to appear excessively eager, Geithner refused the search committee’s suggestion that he write an application and went directly to the interview phase.
Peterson would later say that he had found Geithner disturbingly young-looking and wondered if he was tough enough to say “No!” to Wall Street bankers when necessary. Peterson called Summers. “I wanted to be sure the soft-spokenness, the diffidence, didn’t translate into a lack of courage,” he explained. In an often-repeated anecdote, usually printed without the profanity that peppered Geithner’s conversation, Peterson said, “I told Larry what my concerns were, and Larry burst out laughing. He said, ‘Don’t worry about that, Pete. He’s the only person who ever worked with me who’d walk into my office and say to me, ‘Larry, on this one, you’re full of shit.’”
By tradition, the president of the Federal Reserve Bank of New York serves as vice chairman of the FOMC. Geithner’s immediate predecessor, Bill McDonough, a former banker, usually was the first to speak after Greenspan, almost always responding with fawning enthusiasm. By contrast, Geithner generally waited until everyone else on the committee had spoken and then weighed in, loyal to Bernanke but not a sycophant. His capacity to size up a situation and lay out options coherently and calmly won him admirers among the other Musketeers and made him among the most influential advisers not only to Bernanke but also to Treasury’s Paulson, who had a habit of bolting from a telephone call with Geithner and giving his aides orders with the introductory phrase: “Geithner says …”
Paulson, a forceful personality, liked Bernanke and relied on him but sometimes was surprised by his unwillingness or inability to act like the five-star general that he was. He greatly admired and respected Geithner. Treasury staff would chafe and complain to counterparts at the Fed in Washington about Geithner’s outsized influence. Longtime Fed hands would fret that Geithner was so close to Paulson and so sympathetic to the Treasury, where he had worked for years, that he was undermining the Fed’s cherished reputation of being independent of elected politicians.
Despite a well-cultivated image as a diplomat, Geithner grew testy at the persistent second-guessing from those who were far from the chaos of the battlefield. After sparring with the Richmond Fed’s hard-line Jeffrey Lacker at one meeting, Geithner warned him and other Fed bank presidents that their dissents and public hectoring might provoke Congress into stripping them of their vote on interest rates — a possibility that Barney Frank, the chairman of the House Financial Services Committee, had mentioned more than once. Both inside and outside the Fed, Geithner often was seen as too close to the banks, too ready to rush to their rescue. Some of this came with the job, and some of it reflected his long-standing ties to Bob Rubin at Citigroup, the largest of the banks under the New York Fed’s supervision.
This, then, was the core group that was going to face down the worst economic and financial threat since the Great Depression: a brainiac from South Carolina who had once worked summers at the tackiest roadside attraction on I-95; a sober sixty-something bicyclist and technocrat who had the confidence of both the Fed’s Old Guard and new leadership; an ambitious thirty-something Republican investment banker; and a diplomat whose cool demeanor masked an iron will.
Chapter 7
RE: RE: RE: RE: RE: RE: BLUE SKY
On the afternoon of August 9, 2007, only hours after the Fed had joined the European Central Bank in throwing money on the table, Ben Bernanke assembled the Musketeers. He wanted to brainstorm or, as he put, to “blue sky.” One of Bernanke’s e-mails on the subject circulated so furiously around the Fed that by day’s end the subject heading read: “RE: RE: RE: RE: RE: RE: Blue Sky.” (Unlike Paulson, Bernanke was a BlackBerry addict.) The iterations tell the tale: the moment was growing urgent.
At that afternoon huddle, Bernanke and Warsh sat close to the coffee table in Bernanke’s office so they could be heard on the Polycom speakerphone. Kohn was in his car on the way to a wedding in New England, talking on a cell phone while handing quarters for tolls to his wife, who was doing the driving. Geithner phoned in from his vacation on Cape Cod. Although they were scattered from Washington through the Northeast, the Four Musketeers were of one mind: they had misjudged the severity of the problem.
That same day, unseen by the public and well beneath the shadows cast by the ECB and Fed actions, the St. Louis Federal Reserve Bank sent up a flare. It was an unlikely source. Bill Poole, the seventy-year-old economist trained at the University of Chicago in Milton Friedman’s heyday and now the St. Louis Fed’s president, was more determined to resist inflation than many others at the Fed and was prone to dissent in favor of higher interest rates. But at a meeting of the St. Louis Fed’s board of directors, Poole sought a request to cut the discount rate — the rate that the Fed charges on loans it makes directly to individual banks. (The phrase “discount window” refers to the Fed’s original practice of “discounting” — or buying at a discount from the face value — IOUs that businesses had given banks. The size of the discount these days is known as “a haircut.” The riskier the security offered as collateral for a discount-window loan, the bigger the haircut.) Such requests, though technically from the private-sector directors of a district Fed bank, are a way for a Fed bank president to signal his or her druthers on interest rates. They are closely guarded secrets; no one outside the Fed knew. Poole said later he had been stunned by the severe strains in the market for commercial paper: short-term corporate IOUs.
The next day, Bernanke started early, convening a 7 A.M. conference call with the Fed governors in Washington and the presidents of the twelve regional banks. They agreed to do the first thing that the Fed always does in a crisis: try the calming effect of words. There would be neither action nor a stated change in policy, only a promise to provide enough money to keep the federal funds rate close to its 5.25 percent target and to lend through the discount window.
Their job was to keep the banking system functioning by serving as the lender of last resort at a time of stress, and the banks, at least at this point, weren’t facing a run from depositors. In the infinitely more complicated financial system of the twenty-first century, though, ancient nostrums were running up against intractable modern realities.
While they weren’t facing runs, banks were increasingly reluctant to lend to one another, and other parts of the money markets were showing signs of malfunction. This was threatening to freeze the pistons of the economy. One vulnerable market was the one where financial houses borrowed money overnight from money market funds and other institutional investors with spare cash, the “tri-party repo market.” The word repo is short for “repurchase.” In the standard deal, the borrower sells a security to a lender and agrees to repurchase it at a fixed price later. In effect, a repo is an overnight mortgage. In the same way that a homeowner pledges a house to the bank in exchange for a loan, a financial institution pledges a bond in exchange for funds. If the borrower doesn’t pay back the loan, the lender gets the bond, often a U.S. Treasury note or mortgage-backed security of some sort. The “tri-party” term refers to a three-cornered arrangement that was devised in the mid-1980s after the collapse of a couple of dealers in government securities. Two banks dominate the middleman part of the business, Bank of New York Mellon and the ubiquitous JPMorgan Chase.
The tri-party repo market was just one manifestation of the ways finance had moved away from traditional banking, the business that the Fed was accustomed to supervising. “The structure of the financial system changed fundamentally during the boom, with dramatic growth in the share of assets outside the traditional banking system,” Geithner said. The overall repo market had boomed over the past couple of decades. In 1990, the market amounted to $372 billion, or roughly 13 percent of the size of the $2.8 trillion in federally insured bank deposits. By 2007, the market had grown to $2.6 trillion, equal to 60 percent of the $4.3 trillion in bank deposits. A market practice that had evolved in response to a 1980s vulnerability was creating a new one in the 2000s.
One of the first to get crushed was California’s Countrywide Financial. One of the nation’s largest and most aggressive mortgage lenders, Countrywide was cofounded in the 1970s by Angelo Mozilo, the entrepreneurial son of a Bronx butcher who rode the subprime roller coaster up and then down. Countrywide used the “originate and distribute” model of spreading risk around: it bought mortgages, then quickly sold them to Fannie Mae and Freddie Mac and others. In June 2009, Mozilo was formally accused by the Securities and Exchange Commission of securities fraud for misleading investors of the risks the company was taking to maintain its market share from 2005 through 2007. In an April 2006 e-mail released by the SEC, Mozilo referred to one Countrywide mortgage product and told a top lieutenant: “In all my years in the business I have never seen a more toxic prduct [sic].”
Unlike traditional banks, Countrywide relied heavily on borrowing overnight in money markets to finance loans that hadn’t yet been sold, often using the tri-party repo market. That proved to be a major vulnerability as the Great Panic tightened up lending. Countrywide was now increasingly being viewed as risky, and the downward slide in its stock price accelerated. Countrywide shares, which had been trading at $42 at the beginning of 2007, fell below $30 at the end of July and below $20 in mid-August. (They would end 2007 at $8.94.)
By mid-August, growing anxiety around mortgages, however, was putting the value of Countrywide’s collateral in doubt. On the evening of the fifteenth, Bank of New York Mellon, the middleman with whom Countrywide dealt, told the New York Fed that unless Countrywide came up with more collateral, it wouldn’t give investors their cash the next morning, and would instead pay them with Countrywide’s securities. Tim Geithner knew what was at stake: money market funds wouldn’t want the securities and would try to sell them immediately, creating a fire sale of billions of dollars in securities dumped onto an already jittery market.
Geithner mediated talks that stretched past midnight, at which point he left, telling his staff to call if discussions fell apart. Eventually, the two sides agreed on additional collateral. “We worked it out beautifully,” Countrywide CEO Mozilo told the Wall Street Journal. Bullet dodged, or so it appeared.
BERNANKE’S DASHBOARD
August 16, 2007
Change from
August 7, 2007
Dow Jones Industrial Average: 12,846 down 4.9%
Market Cap of Citigroup: $236.4 billion down 2.2%
Price of Oil (per barrel): $71.01 down 2.0%
Unemployment Rate: 4.7% —
Fed Funds Interest Rate: 5.25% —
Financial Stress Indicator: 0.61 pp up 0.49 pp
The next morning, August 16, Countrywide made public that it was drawing down its $11.5 billion credit lines, unnerving the markets. (Within a week, it had sold a $2 billion stake to Bank of America, which later acquired the whole company.) Countrywide was an early warning of the susceptibility of the tri-party repo market to sudden bouts of distrust among big players in financial markets, the same virulent distrust that would sink Bear Stearns seven months later.
At 6 P.M. on the sixteenth, Bernanke convened a videoconference of the entire FOMC. The Fed’s cavernous boardroom — so well fortified that it was used for meetings between U.S. and British military chiefs during World War II — isn’t equipped with video. So Bernanke and the other governors used a small conference room nearby, known as “the special library,” and faced a TV screen that was wheeled in on a cart. Each regional Fed bank president appeared on the screen in his or her own box, the outline of which was highlighted when the person spoke. A couple of Fed presidents dubbed it Hollywood Squares, after the TV game show. They joked about leaning over and punching the president in the next box if there was a disagreement.
Bernanke had devised a two-pronged response with the other Musketeers. The first was to reduce the rate at which the Fed lent directly to banks by one-half percentage point and let banks borrow for thirty days, instead of the usual overnight. The point was to lubricate the economy, not add more fuel. The Fed long had charged a penalty — one percentage point above the federal funds rate — on loans from its discount window so that banks would have good reason to keep themselves healthy enough to borrow more cheaply from other banks in the federal funds market.
Rick Mishkin, the Fed governor, applauded the Bernanke innovation as an attempt to put more liquidity into the markets without increasing the total amount of credit, targeting the remedy at what appeared to be the most serious symptom at the moment. A student of the history of financial crises, Mishkin was convinced that this was the opening act of what could be a much more serious crisis and argued that the Fed needed to be very aggressive very quickly. In a fifteen-minute conversation before the FOMC meeting, he had told Bernanke that he wanted an even bigger cut in the discount rate and said so at the meeting itself. On the other side, Jeff Lacker of the Richmond Fed didn’t want to cut the discount rate at all, and told Bernanke as much.
The second prong of Bernanke’s action plan was more conventional: crafting words to undo the impression left at the end of the FOMC meeting ten days prior that the Fed was fixated on inflation. Don Kohn, as a veteran of Greenspan’s artful market communication, considered this more important and worked on the wording of the sentences with Brian Madigan, a tall, red-bearded career Fed economist who now was in the pivotal monetary-affairs staff job that Kohn had once held.
“DOWNSIDE RISKS”
To those fluent in Fedspeak, the Friday-morning message of August 17 was clear: a cut in interest rates was now on the table for the first time in Bernanke’s tenure. “Downside risks to growth have increased appreciably” (Translation: It’s going to be worse than we anticipated), and the Fed “is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.” (Translation: We will cut rates unless markets turn around soon.)
Theater and substance wound around each other. At moments of panic, the financial system acts less like the automobile engine of the favorite metaphor and more like a collection of worried people, with emotions and trust that wax and wane. When people are concerned about money, they make choices — such as delaying purchases, hoarding cash, distrusting each other — that are completely rational acts of self-preservation but that worsen an already bad situation.
A successful central bank attacks on both fronts, and that’s what Bernanke had hoped to do. The substance: the Fed belatedly acknowledged that a weakening economy meant that it would cut the interest rate that mattered most, the federal funds rate. The theater: the Fed was shouting that it was eager to lend to cash-short banks through the discount window. But banks were reluctant to borrow from the discount window because doing so, if word leaked, could be seen as a sign of their own financial weakness. If a bank suddenly stopped bidding for short-term funds in the open market, others would guess that it had gone to the Fed. The Fed hoped to dispel that stigma.
Geithner and Kohn convened an unusual conference call with bankers and urged the strong and weak alike to borrow from the discount window. The first to do so — the American arm of Germany’s biggest bank, Deutsche Bank — quietly let the press know, figuring other banks would be doing the same. But none of the others did initially, embarrassing Deutsche. So the Fed cajoled four big banks into borrowing $500 million each and saying so loudly.
The effort was a flop. “The thing about ‘lending freely and at a penalty rate’ only works when people want to borrow,” Kohn said, referring to Bagehot’s prescription. Banks, it turned out, didn’t want to borrow sufficiently at the discount window to lubricate the system.
Bernanke, though, didn’t have time to ponder what Greenspan might have done, or even to mull over if there was something he and his lieutenants might have done differently. Events were moving too fast for that. He canceled plans to join his family on vacation in Charlotte, North Carolina, and Myrtle Beach, South Carolina. He no longer even had time to shoot baskets with the staff in the Fed gym, although he did occasionally don T-shirt and shorts to shoot baskets alone.
Until August 2007, the Fed was something like a firehouse in a town of brick houses: long stretches of boredom punctuated by the occasional one-alarm blaze. The pace was slow, the routine almost unvarying. That changed in August. Now the houses were frame, the weather bone dry, and the alarms were ringing incessantly. In response, the Four Musketeers began a series of daily early-morning and late-afternoon conference calls with key staffers to monitor markets and reassess strategy.
RETHINKING GREENSPAN
