In FED We Trust, page 18
“I would be very cautious about opening that window more generally,” he told Christopher Dodd, chairman of the Senate Banking Committee.
All that was before, though.
After Bear Stearns, potential buyers of any failing financial institution — Lehman Brothers, Wachovia — would ask the Fed not whether it would lend, but how much it was willing to kick in.
After Bear Stearns, the debate would not be whether the Great Panic would require government bailouts but would instead be who would be bailed out and on what terms.
After Bear Stearns, the line between Fed-protected, deposit-taking Main Street banks and less tightly regulated, more leveraged Wall Street investment banks was obliterated.
After Bear Stearns, the Fed’s elastic interpretation of its power to lend to almost anyone in “unusual and exigent circumstances” would lead the Bush administration to see the Fed as the lender of first resort, rather than in its traditional role as the lender of last resort.
After Bear Stearns, although not immediately, many members of Congress would realize for the very first time just how much power Ben Bernanke wielded and how much money was at his disposal.
Seeing imminent danger to the financial system, Bernanke and the New York Fed’s Tim Geithner had no choice but to improvise, but this was improv with stakes greater than those at any time since the 1930s. In pushing the loan for Bear Stearns, the two were discarding decades of practice intended to discourage investors and institutions from taking reckless risks on the expectation that they would profit if they were lucky and the Fed would rescue them if they weren’t.
“Central banks typically have rules. When the rules cannot easily be broken … there is frequently trouble,” the late economic historian Charles Kindleberger wrote in his classic, Manias, Panics and Crashes. “There is also trouble when rules are too readily broken.”
Or as Berkeley economist and blogger Brad DeLong paraphrased him during the Great Panic: in normal times, the central bank’s appearance should always be in doubt. But it should always show up when really needed. The Fed, it was clear, was “really needed.”
“WHEN CONFIDENCE GOES, IT GOES”
By late winter 2007, all of Wall Street was confronting losses on bad mortgage investments and displaying extraordinary reluctance to lend even to one another. The shadow banking system — investment banks, hedge funds, private-equity funds, producers of and investors in securitized loans — had grown larger than the core of the banking system that the Fed was created to protect. The lesson drawn from the Panic of 1907 that led to the creation of the Fed was that banks play a unique and vital role in the economy: they take deposits and borrowed short term (the savings of the society), and they lend money for the long term to finance the investments of the society. This mismatch between taking money that can be withdrawn at any time and lending it in ways that will be paid back only over time makes them vulnerable. So they are required to set aside some money for emergencies, maintain substantial capital cushions to absorb losses, submit to government regulation to restrain them from taking imprudent risks, and are offered the privilege of borrowing from the Fed in a crisis.
After the Depression, the government tried to give savers confidence that their money was safe by offering them government-backed insurance on their deposits. It created the Securities and Exchange Commission to assure stock market investors that the game wasn’t rigged. And, with the Glass-Steagall Act of 1933 (pushed by the same Carter Glass who had played such a big role in creating the Fed), it built a wall between traditional banking (lending money) and what was seen as the riskier business of investment banking (helping companies raise money by selling securities and trading those securities).
These rules could be a nuisance to the banks and could limit their profits. So institutions outside the core banks — sometimes owned by the same parent companies — grew and evolved to dominate the financial system. Encouraged by Greenspan, Congress repealed the Glass-Steagall Act in 1999. Big financial firms grew into banking-insurance-brokerage-trading behemoths like Citigroup. Investment banks, supposedly just outside the Fed’s safety net, became a bigger, more vital part of the system. As loans were made by one outfit, packaged into securities by another and sold to investors, and then other outfits bought and sold insurance (called “credit default swaps”) on those loans, the “shadow banking system” outside the brand-name, Fed-protected commercial banks exploded with a bewildering array of securities, each with its own acronym.
The U.S. financial regulatory system had not kept up with this change. In a division of labor that dated to the 1930s, the Fed and other bank regulators kept a close eye, sometimes not close enough, to be sure, on the banks. The Securities and Exchange Commission worried about the big securities firms (Bear Stearns, Lehman Brothers, Goldman Sachs, and the like), but more to protect their customers’ money and to enforce laws about disclosure and fraud than to make sure that the firms didn’t put the entire financial system in harm’s way. The walls dividing those businesses had eroded over time, and Congress had undone much of the New Deal legislation without finishing the job of reconstructing the financial regulatory apparatus, which was shared by a bewildering number of federal and state agencies of varying competence.
It was fine in good times. “The bottom line is simple: shadow banks use funding instruments that are not just as good as old-fashioned [government]-protected deposits,” said Paul McCulley, who periodically offered acerbic comments from his post as a portfolio manager at Pimco, a big West Coast bond manager. “But it was a great gig so long as the public bought the notion that such funding instruments were ‘just as good’ as bank deposits — more leverage, less regulation and more asset freedom were a path to (much) higher returns on equity in shadow banks than conventional banks.”
Suddenly, the times weren’t so good. The “public” — or at least big-money investors — didn’t view the shadow banks as quite so safe, and grew reluctant to provide the short-term money on which the shadow banks depended. In proliferating numbers, Wall Street executives were beseeching the Fed for the same loans available to ordinary commercial banks at times of duress.
Of all the firms on the Street, Bear Stearns was widely regarded as the weakest link. Funds it managed had been among the early high-profile victims of the subprime mess. Just as bad, the firm was thought to suffer from a severe leadership vacuum. The Wall Street Journal, in a devastating front-page November 1, 2007, story described the CEO, Jimmy Cayne, as a detached, marijuana-smoking executive who spent more time playing bridge than tending his company. Cayne, who had almost died the previous September from a severe prostate infection, stepped down in January.
On Monday, March 10, 2008, Moody’s Investors Service downgraded mortgage-backed debt issued by a Bear Stearns fund, and with that, rumors began to circulate in the market that there were liquidity problems at Bear Stearns itself. Bear Stearns denied the rumors, but the market ignored the denials. When new CEO Alan Schwartz went on CNBC Wednesday to try to shore up confidence in the firm’s finances, his appearance got upstaged by news that New York’s governor Eliot Spitzer was resigning after law-enforcement authorities discovered his dalliance with prostitutes. The run on Bear Stearns continued.
Bob Steel, the former Goldman executive who had come to Treasury to serve as Paulson’s undersecretary for domestic finance, told his boss: “They’ve got a month or so.”
“I don’t buy that,” Paulson said. “When confidence goes, it goes.” He was right.
UNCLOGGING THE CREDIT CHANNEL
For weeks, the Fed had been looking for a way to aid Wall Street by lubricating markets that weren’t functioning well. The week of March 10, as Bear Stearns edged toward the precipice, the Fed finally offered securities houses a deal: give us your troubled assets yearning to be sold, the wretched refuse of your lending. Specifically, the Fed created the Term Securities Lending Facility (or TSLF) to take up to $200 billion worth of Wall Street’s hard-to-sell mortgage-backed securities and exchange them for supersafe U.S. Treasury securities from the Fed’s vast portfolio for up to twenty-eight days.
Like several of the subsequent Fed interventions in the money markets, this one was devised largely by Bill Dudley. An economist with a Ph.D. from the University of California at Berkeley, Dudley had spent twenty years at Goldman Sachs, ending up as its chief U.S. economist. Geithner hired him to run the New York Fed’s markets desk — the place where the Federal Reserve actually buys and sells in the markets. Dudley arrived at the beginning of 2007 in the opening acts of the Great Panic, which turned his new post into a 24/7 job. He even did a press briefing on the TSLF from a hospital room where his wife was recovering from surgery. (When Geithner became Obama’s Treasury secretary, Dudley edged out Fed governor Kevin Warsh to become president of the New York Fed.)
The thinking behind the move was simple: Bernanke was trying to unclog what he dubbed the “credit channel.” Since the investment houses’ collateral was increasingly suspect, he reasoned, giving them a chance to replace bad paper with something nearly as good as cash would get credit flowing again. Confidence would rise. Players would know that even in the event of default, securities with already depressed prices wouldn’t be dumped on the market, avoiding the acceleration of a downward spiral. The TSLF didn’t increase the size of the Fed’s portfolio or the total amount of credit it was providing to the economy. The Fed wasn’t yet printing extra money. But the Fed had taken a big step toward using its portfolio to arrest the Great Panic. By temporarily trading a chunk of its own holdings of the safest securities in the world, U.S. Treasury debt, for the far riskier ones the investment houses would be off-loading from their books, the Fed was expanding its “lender of last resort” protection beyond commercial banks. It was a maneuver designed to offer liquidity to the system but was not a long-term solution, because the investment banks were still on the hook if those securities turned out to be worthless because the ultimate borrowers defaulted. The money wasn’t flowing out yet, but Bernanke and the others had just left the vault door ajar.
BEAR AT THE DOOR
A few hours after the Fed announced the TSLF, Geithner hosted a closed-door lunch for Bernanke in the New York Fed’s Washington Dining Room, one of several get-togethers he had convened so the Fed chairman could meet Wall Street’s brass. Paul Volcker and Alan Greenspan were familiar faces long before they became Fed chairmen. Each had a mystique that conveyed competence and wisdom. But Wall Street was not Bernanke’s milieu, and it showed. “Greenspan was at home at the markets,” one executive at the lunch said. “I don’t think Bernanke has a feel for this stuff.”
That was a problem. The notion that the Fed did banks (Citigroup, Bank of America, JPMorgan Chase) and the SEC did investment houses (Bear Stearns, Lehman Brothers, Goldman Sachs) went up in smoke on Wednesday, March 12.
That evening, Bear CEO Alan Schwartz called Rodgin Cohen, the dean of the banking bar, for strategic advice. Cohen’s firm, Sullivan & Cromwell, wasn’t representing Bear Stearns, although it had handled a few projects for the firm. But Cohen was the go-to banking lawyer in a crisis — so much so that he had ended up with a client in nearly every significant financial controversy in modern memory.
Cohen heard Schwartz out, then said: “We’ve got to call the Fed.” Moments later, the lawyer had Tim Geithner on the phone. “I think I’ve been around long enough to sense a very serious problem, and this seems like one,” he said. That message alone was more dire than anything Bear Stearns had delivered directly to the Fed.
“If Alan is worried, he needs to call me,” Geithner replied.
Schwartz did so the next morning. He explained that, while Bear Stearns was continuing to look for a partner to provide long-term financing, its problems weren’t only long term. Two days earlier, he told Geithner, Bear Stearns had opened for business with $18 billion in cash or securities that were so easily sold that they were as good as cash. By day’s end, $6.5 billion of that was gone. The firm was down to its last $11.5 billion. This was the bad news that builds on itself once word gets out, so the next few days would be deeply challenging.
The problems were the ones that would recur throughout the Great Panic: credit and collateral. Commercial banks use deposits, insured by the government, so they aren’t wholly reliant on short-term borrowing. Investment banks like Bear Stearns hadn’t any deposits, so they were reliant on borrowing in the markets, often overnight. Bear had pledged collateral in the repo market, the market that had caused a scare for Geithner in the Countrywide episode months earlier. The repo market, in its collective wisdom, had now decided that Bear Stearns collateral wasn’t good enough to secure loans, even when that collateral was U.S. Treasury securities.
Bear couldn’t borrow, and without borrowing, it couldn’t do business. It was the twenty-first-century equivalent of a bank run in a world organized for twentieth-century finance. “I just never, frankly, understood or dreamed it could happen as rapidly as it did,” Bear Stearns’s Schwartz said.
Neither did Geithner nor Bernanke. In fact, though, the problem — the reliance on borrowing in the wholesale markets to keep the business going without realizing how ephemeral credit was — had been building for a long time.
Months later, Fed governor Kevin Warsh tried to put it in perspective. “You know that line in Fletch when Chevy Chase tells a doctor that it was a shame that ‘Ed’ died so suddenly. ‘He was in intensive care for eight weeks,’ the doctor says. To which Chevy Chase replies: ‘But in the very end, when he actually died … that was extremely sudden.’”
“Same thing here,” Warsh said about Bear Stearns. “Very sudden, but …”
THE LAST $2 BILLION
By Thursday night, Bear Stearns was down to $2 billion in cash. The company asked Gary Parr, a Lazard Frères investment banker who had been helping the firm to try to raise money, to contact the most likely savior: Jamie Dimon of JPMorgan Chase. Parr interrupted Dimon’s birthday dinner with his family at Avra, a Greek restaurant, and told him Bear needed $30 billion. Dimon balked. Well, Parr replied, how about buying the whole company overnight? Schwartz followed up with a call to Dimon.
Dimon, in turn, called Geithner. JPMorgan didn’t have enough information to make an overnight decision to buy Bear Stearns. “Tim, look,” he said, “we need more time. Just do something to get them to the weekend.”
Geithner took Dimon seriously. Once a contender for the top job at Citicorp before he was tossed out by his mentor, Sandy Weill, in 1998, Dimon was one of a handful of top financial executives to escape the worst of the subprime fiasco. He went from Citi to run Bank One, a big bank based in Ohio that was acquired by JPMorgan in 2004. By 2007, Dimon was at the top of one half of the original J. P. Morgan empire — the other half was at Morgan Stanley. Citi was struggling. Dimon, a Democrat, would have been on the list of potential Obama appointees to the Treasury — the job Geithner eventually got — had a banking résumé not become a disqualification for the post.
Bear Stearns’s fate was in the hands of a very tight fraternity. Dimon was a member of the Federal Reserve Bank of New York’s nine-person board of directors. That board hired Geithner and set his salary, an extraordinary historical anomaly that gives the regulated the power to pick the regulator.
From the beginning, the regional Fed banks were organized not as government agencies, but as private companies in which local banks own shares, a remnant of a time when central banks raised capital privately as well as publicly. Under the 1913 law, each bank has nine directors, the majority chosen by the banks in the district. Three are bankers. Three are nonbankers picked by the local banks. Three are chosen by the Fed board in Washington to represent the public. On the New York Fed’s board, Dimon fell into the first category, a banker picked by bankers. Richard Fuld, CEO of Lehman Brothers, was in the second; since Lehman wasn’t a bank in the legal sense, he was a nonbanker picked by bankers. Stephen Friedman — the former CEO of Goldman Sachs and then a member of Goldman’s board of directors — was in the third, legally a nonbanker picked to represent the public. He chaired the New York Fed board and stayed in close touch with Geithner.
Later in the Great Panic, Goldman would change its legal status and become a Fed-regulated bank-holding company. Under Fed rules, holding shares and sitting on Goldman’s board made Friedman ineligible to represent the public on the New York Fed board. The Fed, with the approval of the Fed governors in Washington, quietly gave Friedman a waiver to serve through the end of 2009, but was embarrassed when the Wall Street Journal reported that he had been adding to his Goldman stake during the tumult of late 2008 as the Fed was making moves that benefited Goldman. Friedman quit the New York Fed board in May 2009. He said his continued presence there was an unwelcome distraction for the Fed, and insisted unapologetically that his actions had been “mischaracterized” and above reproach.
Directors of regional Fed banks didn’t vote to approve Fed loans like the one Bear Stearns was seeking; the loans went to the Fed board in Washington, where all the power was with government employees like Bernanke. And directors weren’t supposed to participate in formal conversations about their own institutions. But the incestuousness was obvious, the kind of crony capitalism that the U.S. government criticized in Indonesia and other developing countries. Geithner was hired by bankers he was supposed to supervise and, now, was being asked to bail out. The arrangement underscored the New York Fed’s peculiar relationship with Wall Street. It was supposed to be a regulator and guardian of the public interest, but sometimes was seen — by banks, by other factions inside the Fed, and by the public — as Wall Street’s advocate, rather than its overseer. And on some days, it was more advocate than overseer.
