By GEORGE MELLOAN
As Congress blithely ushers its trillion dollar "stimulus" package toward law and the U.S. Treasury prepares to begin writing checks on this vast new appropriation, it might be wise to ask a simple question: Who's going to finance it?
That might seem like a no-brainer, which perhaps explains why no one has bothered to ask. Treasury securities are selling at high prices and finding buyers even though yields are low, hovering below 3% for 10-year notes. Congress is able to assure itself that it will finance the stimulus with cheap credit. But how long will credit be cheap? Will it still be when the Treasury is scrounging around in the international credit markets six months or a year from now? That seems highly unlikely.
Let's have a look at the credit market. Treasurys have been strong because the stock market collapse and the mortgage-backed securities fiasco sent the whole world running for safety. The best looking port in the storm, as usual, was U.S. Treasury paper. That is what gave the dollar and Treasury securities the lift they now enjoy.
But that surge was a one-time event and doesn't necessarily mean that a big new batch of Treasury securities will find an equally strong market. Most likely it won't as the global economy spirals downward.
For one thing, a very important cycle has been interrupted by the crash. For years, the U.S. has run large trade deficits with China and Japan and those two countries have invested their surpluses mostly in U.S. Treasury securities. Their holdings are enormous: As of Nov. 30 last year, China held $682 billion in Treasurys, a sharp rise from $459 billion a year earlier. Japan had reduced its holdings, to $577 billion from $590 billion a year earlier, but remains a huge creditor. The two account for almost 65% of total Treasury securities held by foreign owners, 19% of the total U.S. national debt, and over 30% of Treasurys held by the public.
In the lush years of the U.S. credit boom, it was rationalized that this circular arrangement was good for all concerned. Exports fueled China's rapid economic growth and created jobs for its huge work force, American workers could raise their living standards by buying cheap Chinese goods. China's dollar surplus gave the U.S. Treasury a captive pool of investment to finance congressional deficits. It was argued, persuasively, that China and Japan had no choice but to buy U.S. bonds if they wanted to keep their exports to the U.S. flowing. They also would hurt their own interests if they tried to unload Treasurys because that would send the value of their remaining holdings down.
But what if they stopped buying bonds not out of choice but because they were out of money? The virtuous circle so much praised would be broken. Something like that seems to be happening now. As the recession deepens, U.S. consumers are spending less, even on cheap Chinese goods and certainly on Japanese cars and electronic products. Japan, already a smaller market for U.S. debt last November, is now suffering what some have described as "free fall" in industrial production. Its two champions, Toyota and Sony, are faltering badly. China's growth also is slowing, and it is plagued by rising unemployment.
American officials seem not to have noticed this abrupt and dangerous change in global patterns of trade and finance. The new Treasury secretary, Timothy Geithner, at his Senate confirmation hearing harped on that old Treasury mantra about China "manipulating" its currency to gain trade advantage. Vice President Joe Biden followed up with a further lecture to the Chinese but said the U.S. will not move "unilaterally" to keep out Chinese exports. One would hope not "unilaterally" or any other way if the U.S. hopes to keep flogging its Treasurys to the Chinese.
The Congressional Budget Office is predicting the federal deficit will reach $1.2 trillion this fiscal year. That's more than double the $455 billion deficit posted for fiscal 2008, and some private estimates put the likely outcome even higher. That will drive up interest costs in the federal budget even if Treasury yields stay low. But if a drop in world market demand for Treasurys sends borrowing costs upward, there could be a ballooning of the interest cost line in the budget that will worsen an already frightening outlook. Credit for the rest of the economy will become more dear as well, worsening the recession. Treasury's Wednesday announcement that it will sell a record $67 billion in notes and bonds next week and $493 billion in this quarter weakened Treasury prices, revealing market sensitivity to heavy financing.
So what is the outlook? The stimulus package is rolling through Congress like an express train packed with goodies, so an enormous deficit seems to be a given. Entitlements will go up instead of being brought under better control, auguring big future deficits. Where will the Treasury find all those trillions in a depressed world economy?
There is only one answer. The Obama administration and Congress will call on Ben Bernanke at the Fed to demand that he create more dollars -- lots and lots of them. The Fed already is talking of buying longer-term Treasurys to support the market, so it will be more of the same -- much more.
And what will be the result? Well, the product of this sort of thing is called inflation. The Fed's outpouring of dollar liquidity after the September crash replaced the liquidity lost by the financial sector and has so far caused no significant uptick in consumer prices. But the worry lies in what will happen next.
Even when the economy and the securities markets are sluggish, the Fed's financing of big federal deficits can be inflationary. We learned that in the late 1970s, when the Fed's deficit financing sent the CPI up to an annual rate of almost 15%. That confounded the Keynesian theorists who believed then, as now, that federal spending "stimulus" would restore economic health.
Inflation is the product of the demand for money as well as of the supply. And if the Fed finances federal deficits in a moribund economy, it can create more money than the economy can use. The result is "stagflation," a term coined to describe the 1970s experience. As the global economy slows and Congress relies more on the Fed to finance a huge deficit, there is a very real danger of a return of stagflation. I wonder why no one in Congress or the Obama administration has thought of that as a potential consequence of their stimulus package.
Showing posts with label Fed policy. Show all posts
Showing posts with label Fed policy. Show all posts
Sunday, March 01, 2009
Deregulation and the Financial Panic
By Phil Gramm
The debate about the cause of the current crisis in our financial markets is important because the reforms implemented by Congress will be profoundly affected by what people believe caused the crisis.
President Bill Clinton signs the Financial Services Modernization Act of 1999.
If the cause was an unsustainable boom in house prices and irresponsible mortgage lending that corrupted the balance sheets of the world's financial institutions, reforming the housing credit system and correcting attendant problems in the financial system are called for. But if the fundamental structure of the financial system is flawed, a more profound restructuring is required.
I believe that a strong case can be made that the financial crisis stemmed from a confluence of two factors. The first was the unintended consequences of a monetary policy, developed to combat inventory cycle recessions in the last half of the 20th century, that was not well suited to the speculative bubble recession of 2001. The second was the politicization of mortgage lending.
The 2001 recession was brought on when a speculative bubble in the equity market burst, causing investment to collapse. But unlike previous postwar recessions, consumption and the housing industry remained strong at the trough of the recession. Critics of Federal Reserve Chairman Alan Greenspan say he held interest rates too low for too long, and in the process overstimulated the economy. That criticism does not capture what went wrong, however. The consequences of the Fed's monetary policy lay elsewhere.
In the inventory-cycle recessions experienced in the last half of the 20th century, involuntary build up of inventories produced retrenchment in the production chain. Workers were laid off and investment and consumption, including the housing sector, slumped.
In the 2001 recession, however, consumption and home building remained strong as investment collapsed. The Fed's sharp, prolonged reduction in interest rates stimulated a housing market that was already booming -- triggering six years of double-digit increases in housing prices during a period when the general inflation rate was low.
Buyers bought houses they couldn't afford, believing they could refinance in the future and benefit from the ongoing appreciation. Lenders assumed that even if everything else went wrong, properties could still be sold for more than they cost and the loan could be repaid. This mentality permeated the market from the originator to the holder of securitized mortgages, from the rating agency to the financial regulator.
Meanwhile, mortgage lending was becoming increasingly politicized. Community Reinvestment Act (CRA) requirements led regulators to foster looser underwriting and encouraged the making of more and more marginal loans. Looser underwriting standards spread beyond subprime to the whole housing market.
As Mr. Greenspan testified last October at a hearing of the House Committee on Oversight and Government Reform, "It's instructive to go back to the early stages of the subprime market, which has essentially emerged out of CRA." It was not just that CRA and federal housing policy pressured lenders to make risky loans -- but that they gave lenders the excuse and the regulatory cover.
Countrywide Financial Corp. cloaked itself in righteousness and silenced any troubled regulator by being the first mortgage lender to sign a HUD "Declaration of Fair Lending Principles and Practices." Given privileged status by Fannie Mae as a reward for "the most flexible underwriting criteria," it became the world's largest mortgage lender -- until it became the first major casualty of the financial crisis.
The 1992 Housing Bill set quotas or "targets" that Fannie and Freddie were to achieve in meeting the housing needs of low- and moderate-income Americans. In 1995 HUD raised the primary quota for low- and moderate-income housing loans from the 30% set by Congress in 1992 to 40% in 1996 and to 42% in 1997.
By the time the housing market collapsed, Fannie and Freddie faced three quotas. The first was for mortgages to individuals with below-average income, set at 56% of their overall mortgage holdings. The second targeted families with incomes at or below 60% of area median income, set at 27% of their holdings. The third targeted geographic areas deemed to be underserved, set at 35%.
The results? In 1994, 4.5% of the mortgage market was subprime and 31% of those subprime loans were securitized. By 2006, 20.1% of the entire mortgage market was subprime and 81% of those loans were securitized. The Congressional Budget Office now estimates that GSE losses will cost $240 billion in fiscal year 2009. If this crisis proves nothing else, it proves you cannot help people by lending them more money than they can pay back.
Blinded by the experience of the postwar period, where aggregate housing prices had never declined on an annual basis, and using the last 20 years as a measure of the norm, rating agencies and regulators viewed securitized mortgages, even subprime and undocumented Alt-A mortgages, as embodying little risk. It was not that regulators were not empowered; it was that they were not alarmed.
With near universal approval of regulators world-wide, these securities were injected into the arteries of the world's financial system. When the bubble burst, the financial system lost the indispensable ingredients of confidence and trust. We all know the rest of the story.
The principal alternative to the politicization of mortgage lending and bad monetary policy as causes of the financial crisis is deregulation. How deregulation caused the crisis has never been specifically explained. Nevertheless, two laws are most often blamed: the Gramm-Leach-Bliley (GLB) Act of 1999 and the Commodity Futures Modernization Act of 2000.
GLB repealed part of the Great Depression era Glass-Steagall Act, and allowed banks, securities companies and insurance companies to affiliate under a Financial Services Holding Company. It seems clear that if GLB was the problem, the crisis would have been expected to have originated in Europe where they never had Glass-Steagall requirements to begin with. Also, the financial firms that failed in this crisis, like Lehman, were the least diversified and the ones that survived, like J.P. Morgan, were the most diversified.
Moreover, GLB didn't deregulate anything. It established the Federal Reserve as a superregulator, overseeing all Financial Services Holding Companies. All activities of financial institutions continued to be regulated on a functional basis by the regulators that had regulated those activities prior to GLB.
When no evidence was ever presented to link GLB to the financial crisis -- and when former President Bill Clinton gave a spirited defense of this law, which he signed -- proponents of the deregulation thesis turned to the Commodity Futures Modernization Act (CFMA), and specifically to credit default swaps.
Yet it is amazing how well the market for credit default swaps has functioned during the financial crisis. That market has never lost liquidity and the default rate has been low, given the general state of the underlying assets. In any case, the CFMA did not deregulate credit default swaps. All swaps were given legal certainty by clarifying that swaps were not futures, but remained subject to regulation just as before based on who issued the swap and the nature of the underlying contracts.
In reality the financial "deregulation" of the last two decades has been greatly exaggerated. As the housing crisis mounted, financial regulators had more power, larger budgets and more personnel than ever. And yet, with the notable exception of Mr. Greenspan's warning about the risk posed by the massive mortgage holdings of Fannie and Freddie, regulators seemed unalarmed as the crisis grew. There is absolutely no evidence that if financial regulators had had more resources or more authority that anything would have been different.
Since politicization of the mortgage market was a primary cause of this crisis, we should be especially careful to prevent the politicization of the banks that have been given taxpayer assistance. Did Citi really change its view on mortgage cram-downs or was it pressured? How much pressure was really applied to force Bank of America to go through with the Merrill acquisition?
Restrictions on executive compensation are good fun for politicians, but they are just one step removed from politicians telling banks who to lend to and for what. We have been down that road before, and we know where it leads.
Finally, it should give us pause in responding to the financial crisis of today to realize that this crisis itself was in part an unintended consequence of the monetary policy we employed to deal with the previous recession. Surely, unintended consequences are a real danger when the monetary base has been bloated by a doubling of the Federal Reserve's balance sheet, and the federal deficit seems destined to exceed $1.7 trillion.
The debate about the cause of the current crisis in our financial markets is important because the reforms implemented by Congress will be profoundly affected by what people believe caused the crisis.
President Bill Clinton signs the Financial Services Modernization Act of 1999.
If the cause was an unsustainable boom in house prices and irresponsible mortgage lending that corrupted the balance sheets of the world's financial institutions, reforming the housing credit system and correcting attendant problems in the financial system are called for. But if the fundamental structure of the financial system is flawed, a more profound restructuring is required.
I believe that a strong case can be made that the financial crisis stemmed from a confluence of two factors. The first was the unintended consequences of a monetary policy, developed to combat inventory cycle recessions in the last half of the 20th century, that was not well suited to the speculative bubble recession of 2001. The second was the politicization of mortgage lending.
The 2001 recession was brought on when a speculative bubble in the equity market burst, causing investment to collapse. But unlike previous postwar recessions, consumption and the housing industry remained strong at the trough of the recession. Critics of Federal Reserve Chairman Alan Greenspan say he held interest rates too low for too long, and in the process overstimulated the economy. That criticism does not capture what went wrong, however. The consequences of the Fed's monetary policy lay elsewhere.
In the inventory-cycle recessions experienced in the last half of the 20th century, involuntary build up of inventories produced retrenchment in the production chain. Workers were laid off and investment and consumption, including the housing sector, slumped.
In the 2001 recession, however, consumption and home building remained strong as investment collapsed. The Fed's sharp, prolonged reduction in interest rates stimulated a housing market that was already booming -- triggering six years of double-digit increases in housing prices during a period when the general inflation rate was low.
Buyers bought houses they couldn't afford, believing they could refinance in the future and benefit from the ongoing appreciation. Lenders assumed that even if everything else went wrong, properties could still be sold for more than they cost and the loan could be repaid. This mentality permeated the market from the originator to the holder of securitized mortgages, from the rating agency to the financial regulator.
Meanwhile, mortgage lending was becoming increasingly politicized. Community Reinvestment Act (CRA) requirements led regulators to foster looser underwriting and encouraged the making of more and more marginal loans. Looser underwriting standards spread beyond subprime to the whole housing market.
As Mr. Greenspan testified last October at a hearing of the House Committee on Oversight and Government Reform, "It's instructive to go back to the early stages of the subprime market, which has essentially emerged out of CRA." It was not just that CRA and federal housing policy pressured lenders to make risky loans -- but that they gave lenders the excuse and the regulatory cover.
Countrywide Financial Corp. cloaked itself in righteousness and silenced any troubled regulator by being the first mortgage lender to sign a HUD "Declaration of Fair Lending Principles and Practices." Given privileged status by Fannie Mae as a reward for "the most flexible underwriting criteria," it became the world's largest mortgage lender -- until it became the first major casualty of the financial crisis.
The 1992 Housing Bill set quotas or "targets" that Fannie and Freddie were to achieve in meeting the housing needs of low- and moderate-income Americans. In 1995 HUD raised the primary quota for low- and moderate-income housing loans from the 30% set by Congress in 1992 to 40% in 1996 and to 42% in 1997.
By the time the housing market collapsed, Fannie and Freddie faced three quotas. The first was for mortgages to individuals with below-average income, set at 56% of their overall mortgage holdings. The second targeted families with incomes at or below 60% of area median income, set at 27% of their holdings. The third targeted geographic areas deemed to be underserved, set at 35%.
The results? In 1994, 4.5% of the mortgage market was subprime and 31% of those subprime loans were securitized. By 2006, 20.1% of the entire mortgage market was subprime and 81% of those loans were securitized. The Congressional Budget Office now estimates that GSE losses will cost $240 billion in fiscal year 2009. If this crisis proves nothing else, it proves you cannot help people by lending them more money than they can pay back.
Blinded by the experience of the postwar period, where aggregate housing prices had never declined on an annual basis, and using the last 20 years as a measure of the norm, rating agencies and regulators viewed securitized mortgages, even subprime and undocumented Alt-A mortgages, as embodying little risk. It was not that regulators were not empowered; it was that they were not alarmed.
With near universal approval of regulators world-wide, these securities were injected into the arteries of the world's financial system. When the bubble burst, the financial system lost the indispensable ingredients of confidence and trust. We all know the rest of the story.
The principal alternative to the politicization of mortgage lending and bad monetary policy as causes of the financial crisis is deregulation. How deregulation caused the crisis has never been specifically explained. Nevertheless, two laws are most often blamed: the Gramm-Leach-Bliley (GLB) Act of 1999 and the Commodity Futures Modernization Act of 2000.
GLB repealed part of the Great Depression era Glass-Steagall Act, and allowed banks, securities companies and insurance companies to affiliate under a Financial Services Holding Company. It seems clear that if GLB was the problem, the crisis would have been expected to have originated in Europe where they never had Glass-Steagall requirements to begin with. Also, the financial firms that failed in this crisis, like Lehman, were the least diversified and the ones that survived, like J.P. Morgan, were the most diversified.
Moreover, GLB didn't deregulate anything. It established the Federal Reserve as a superregulator, overseeing all Financial Services Holding Companies. All activities of financial institutions continued to be regulated on a functional basis by the regulators that had regulated those activities prior to GLB.
When no evidence was ever presented to link GLB to the financial crisis -- and when former President Bill Clinton gave a spirited defense of this law, which he signed -- proponents of the deregulation thesis turned to the Commodity Futures Modernization Act (CFMA), and specifically to credit default swaps.
Yet it is amazing how well the market for credit default swaps has functioned during the financial crisis. That market has never lost liquidity and the default rate has been low, given the general state of the underlying assets. In any case, the CFMA did not deregulate credit default swaps. All swaps were given legal certainty by clarifying that swaps were not futures, but remained subject to regulation just as before based on who issued the swap and the nature of the underlying contracts.
In reality the financial "deregulation" of the last two decades has been greatly exaggerated. As the housing crisis mounted, financial regulators had more power, larger budgets and more personnel than ever. And yet, with the notable exception of Mr. Greenspan's warning about the risk posed by the massive mortgage holdings of Fannie and Freddie, regulators seemed unalarmed as the crisis grew. There is absolutely no evidence that if financial regulators had had more resources or more authority that anything would have been different.
Since politicization of the mortgage market was a primary cause of this crisis, we should be especially careful to prevent the politicization of the banks that have been given taxpayer assistance. Did Citi really change its view on mortgage cram-downs or was it pressured? How much pressure was really applied to force Bank of America to go through with the Merrill acquisition?
Restrictions on executive compensation are good fun for politicians, but they are just one step removed from politicians telling banks who to lend to and for what. We have been down that road before, and we know where it leads.
Finally, it should give us pause in responding to the financial crisis of today to realize that this crisis itself was in part an unintended consequence of the monetary policy we employed to deal with the previous recession. Surely, unintended consequences are a real danger when the monetary base has been bloated by a doubling of the Federal Reserve's balance sheet, and the federal deficit seems destined to exceed $1.7 trillion.
How Government Created the Financial Crisis
By JOHN B. TAYLOR
Many are calling for a 9/11-type commission to investigate the financial crisis. Any such investigation should not rule out government itself as a major culprit. My research shows that government actions and interventions -- not any inherent failure or instability of the private economy -- caused, prolonged and dramatically worsened the crisis.
The classic explanation of financial crises is that they are caused by excesses -- frequently monetary excesses -- which lead to a boom and an inevitable bust. This crisis was no different: A housing boom followed by a bust led to defaults, the implosion of mortgages and mortgage-related securities at financial institutions, and resulting financial turmoil.
Monetary excesses were the main cause of the boom. The Fed held its target interest rate, especially in 2003-2005, well below known monetary guidelines that say what good policy should be based on historical experience. Keeping interest rates on the track that worked well in the past two decades, rather than keeping rates so low, would have prevented the boom and the bust. Researchers at the Organization for Economic Cooperation and Development have provided corroborating evidence from other countries: The greater the degree of monetary excess in a country, the larger was the housing boom.
The effects of the boom and bust were amplified by several complicating factors including the use of subprime and adjustable-rate mortgages, which led to excessive risk taking. There is also evidence the excessive risk taking was encouraged by the excessively low interest rates. Delinquency rates and foreclosure rates are inversely related to housing price inflation. These rates declined rapidly during the years housing prices rose rapidly, likely throwing mortgage underwriting programs off track and misleading many people.
Adjustable-rate, subprime and other mortgages were packed into mortgage-backed securities of great complexity. Rating agencies underestimated the risk of these securities, either because of a lack of competition, poor accountability, or most likely the inherent difficulty in assessing risk due to the complexity.
Other government actions were at play: The government-sponsored enterprises Fannie Mae and Freddie Mac were encouraged to expand and buy mortgage-backed securities, including those formed with the risky subprime mortgages.
Government action also helped prolong the crisis. Consider that the financial crisis became acute on Aug. 9 and 10, 2007, when money-market interest rates rose dramatically. Interest rate spreads, such as the difference between three-month and overnight interbank loans, jumped to unprecedented levels.
Diagnosing the reason for this sudden increase was essential for determining what type of policy response was appropriate. If liquidity was the problem, then providing more liquidity by making borrowing easier at the Federal Reserve discount window, or opening new windows or facilities, would be appropriate. But if counterparty risk was behind the sudden rise in money-market interest rates, then a direct focus on the quality and transparency of the bank's balance sheets would be appropriate.
Early on, policy makers misdiagnosed the crisis as one of liquidity, and prescribed the wrong treatment.
To provide more liquidity, the Fed created the Term Auction Facility (TAF) in December 2007. Its main aim was to reduce interest rate spreads in the money markets and increase the flow of credit. But the TAF did not seem to make much difference. If the reason for the spread was counterparty risk as distinct from liquidity, this is not surprising.
Another early policy response was the Economic Stimulus Act of 2008, passed in February. The major part of this package was to send cash totaling over $100 billion to individuals and families so they would have more to spend and thus jump-start consumption and the economy. But people spent little if anything of the temporary rebate (as predicted by Milton Friedman's permanent income theory, which holds that temporary as distinct from permanent increases in income do not lead to significant increases in consumption). Consumption was not jump-started.
A third policy response was the very sharp reduction in the target federal-funds rate to 2% in April 2008 from 5.25% in August 2007. This was sharper than monetary guidelines such as my own Taylor Rule would prescribe. The most noticeable effect of this rate cut was a sharp depreciation of the dollar and a large increase in oil prices. After the start of the crisis, oil prices doubled to over $140 in July 2008, before plummeting back down as expectations of world economic growth declined. But by then the damage of the high oil prices had been done.
After a year of such mistaken prescriptions, the crisis suddenly worsened in September and October 2008. We experienced a serious credit crunch, seriously weakening an economy already suffering from the lingering impact of the oil price hike and housing bust.
Many have argued that the reason for this bad turn was the government's decision not to prevent the bankruptcy of Lehman Brothers over the weekend of Sept. 13 and 14. A study of this event suggests that the answer is more complicated and lay elsewhere.
While interest rate spreads increased slightly on Monday, Sept. 15, they stayed in the range observed during the previous year, and remained in that range through the rest of the week. On Friday, Sept. 19, the Treasury announced a rescue package, though not its size or the details. Over the weekend the package was put together, and on Tuesday, Sept. 23, Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson testified before the Senate Banking Committee. They introduced the Troubled Asset Relief Program (TARP), saying that it would be $700 billion in size. A short draft of legislation was provided, with no mention of oversight and few restrictions on the use of the funds.
The two men were questioned intensely and the reaction was quite negative, judging by the large volume of critical mail received by many members of Congress. It was following this testimony that one really begins to see the crisis deepening and interest rate spreads widening.
The realization by the public that the government's intervention plan had not been fully thought through, and the official story that the economy was tanking, likely led to the panic seen in the next few weeks. And this was likely amplified by the ad hoc decisions to support some financial institutions and not others and unclear, seemingly fear-based explanations of programs to address the crisis. What was the rationale for intervening with Bear Stearns, then not with Lehman, and then again with AIG? What would guide the operations of the TARP?
It did not have to be this way. To prevent misguided actions in the future, it is urgent that we return to sound principles of monetary policy, basing government interventions on clearly stated diagnoses and predictable frameworks for government actions.
Massive responses with little explanation will probably make things worse. That is the lesson from this crisis so far.
Many are calling for a 9/11-type commission to investigate the financial crisis. Any such investigation should not rule out government itself as a major culprit. My research shows that government actions and interventions -- not any inherent failure or instability of the private economy -- caused, prolonged and dramatically worsened the crisis.
The classic explanation of financial crises is that they are caused by excesses -- frequently monetary excesses -- which lead to a boom and an inevitable bust. This crisis was no different: A housing boom followed by a bust led to defaults, the implosion of mortgages and mortgage-related securities at financial institutions, and resulting financial turmoil.
Monetary excesses were the main cause of the boom. The Fed held its target interest rate, especially in 2003-2005, well below known monetary guidelines that say what good policy should be based on historical experience. Keeping interest rates on the track that worked well in the past two decades, rather than keeping rates so low, would have prevented the boom and the bust. Researchers at the Organization for Economic Cooperation and Development have provided corroborating evidence from other countries: The greater the degree of monetary excess in a country, the larger was the housing boom.
The effects of the boom and bust were amplified by several complicating factors including the use of subprime and adjustable-rate mortgages, which led to excessive risk taking. There is also evidence the excessive risk taking was encouraged by the excessively low interest rates. Delinquency rates and foreclosure rates are inversely related to housing price inflation. These rates declined rapidly during the years housing prices rose rapidly, likely throwing mortgage underwriting programs off track and misleading many people.
Adjustable-rate, subprime and other mortgages were packed into mortgage-backed securities of great complexity. Rating agencies underestimated the risk of these securities, either because of a lack of competition, poor accountability, or most likely the inherent difficulty in assessing risk due to the complexity.
Other government actions were at play: The government-sponsored enterprises Fannie Mae and Freddie Mac were encouraged to expand and buy mortgage-backed securities, including those formed with the risky subprime mortgages.
Government action also helped prolong the crisis. Consider that the financial crisis became acute on Aug. 9 and 10, 2007, when money-market interest rates rose dramatically. Interest rate spreads, such as the difference between three-month and overnight interbank loans, jumped to unprecedented levels.
Diagnosing the reason for this sudden increase was essential for determining what type of policy response was appropriate. If liquidity was the problem, then providing more liquidity by making borrowing easier at the Federal Reserve discount window, or opening new windows or facilities, would be appropriate. But if counterparty risk was behind the sudden rise in money-market interest rates, then a direct focus on the quality and transparency of the bank's balance sheets would be appropriate.
Early on, policy makers misdiagnosed the crisis as one of liquidity, and prescribed the wrong treatment.
To provide more liquidity, the Fed created the Term Auction Facility (TAF) in December 2007. Its main aim was to reduce interest rate spreads in the money markets and increase the flow of credit. But the TAF did not seem to make much difference. If the reason for the spread was counterparty risk as distinct from liquidity, this is not surprising.
Another early policy response was the Economic Stimulus Act of 2008, passed in February. The major part of this package was to send cash totaling over $100 billion to individuals and families so they would have more to spend and thus jump-start consumption and the economy. But people spent little if anything of the temporary rebate (as predicted by Milton Friedman's permanent income theory, which holds that temporary as distinct from permanent increases in income do not lead to significant increases in consumption). Consumption was not jump-started.
A third policy response was the very sharp reduction in the target federal-funds rate to 2% in April 2008 from 5.25% in August 2007. This was sharper than monetary guidelines such as my own Taylor Rule would prescribe. The most noticeable effect of this rate cut was a sharp depreciation of the dollar and a large increase in oil prices. After the start of the crisis, oil prices doubled to over $140 in July 2008, before plummeting back down as expectations of world economic growth declined. But by then the damage of the high oil prices had been done.
After a year of such mistaken prescriptions, the crisis suddenly worsened in September and October 2008. We experienced a serious credit crunch, seriously weakening an economy already suffering from the lingering impact of the oil price hike and housing bust.
Many have argued that the reason for this bad turn was the government's decision not to prevent the bankruptcy of Lehman Brothers over the weekend of Sept. 13 and 14. A study of this event suggests that the answer is more complicated and lay elsewhere.
While interest rate spreads increased slightly on Monday, Sept. 15, they stayed in the range observed during the previous year, and remained in that range through the rest of the week. On Friday, Sept. 19, the Treasury announced a rescue package, though not its size or the details. Over the weekend the package was put together, and on Tuesday, Sept. 23, Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson testified before the Senate Banking Committee. They introduced the Troubled Asset Relief Program (TARP), saying that it would be $700 billion in size. A short draft of legislation was provided, with no mention of oversight and few restrictions on the use of the funds.
The two men were questioned intensely and the reaction was quite negative, judging by the large volume of critical mail received by many members of Congress. It was following this testimony that one really begins to see the crisis deepening and interest rate spreads widening.
The realization by the public that the government's intervention plan had not been fully thought through, and the official story that the economy was tanking, likely led to the panic seen in the next few weeks. And this was likely amplified by the ad hoc decisions to support some financial institutions and not others and unclear, seemingly fear-based explanations of programs to address the crisis. What was the rationale for intervening with Bear Stearns, then not with Lehman, and then again with AIG? What would guide the operations of the TARP?
It did not have to be this way. To prevent misguided actions in the future, it is urgent that we return to sound principles of monetary policy, basing government interventions on clearly stated diagnoses and predictable frameworks for government actions.
Massive responses with little explanation will probably make things worse. That is the lesson from this crisis so far.
Saturday, February 07, 2009
From Awful to Merely Bad: Reviewing the Bank Rescue Options
Source: WSJ, Authors: Hubbard, Scott, and Zingales
When Henry Paulson, President Bush's Treasury secretary, first introduced the Troubled Asset Relief Program (TARP) in Congress last September, we cautioned against using government funds to buy mortgages and mortgage-related securities from banks. After the Emergency Economic Stabilization Act was signed into law in early October, the Treasury decided not to buy these assets. Instead, it used the first $350 billion of TARP funds to inject capital first into nine systemically important troubled banks, and later into insurer AIG (as part of a refinancing) and auto makers General Motors and Chrysler.
This approach seems to have achieved (albeit at a high cost for taxpayers) its principal objective of avoiding a massive collapse of the financial system. But it has not yet resulted in an increase in bank lending or the attraction of new private equity to the banking system, both of which are important to reviving the economy. There now appears to be active consideration of using TARP funds to buy "bad assets" from the banks. Major problems with so doing remain.
The central issue is how to price the assets. When the subprime crisis hit in the summer of 2007, the Treasury's first response was to encourage the private sector to create a fund -- the so-called Super SIV (structured investment vehicle) -- to buy mortgage-related assets. This proposal foundered due to the difficulty of setting a price for these assets, which come in complex and incomparable varieties. If Treasury pays close to par, it is paying far too much. If it pays current prices, no one will sell because of the adverse impact on their capital. If it pulls a price out of a hat, it will be acting arbitrarily.
Initial discussions focused on using a reverse auction with asset holders "bidding" to sell their mortgage-related securities to the Treasury. Such an approach raises significant problems -- most significant is the risk posed by asymmetric information regarding the value of these securities. Because the holders of complex and incomparable mortgage-related securities have more information regarding their worth than does Treasury, Treasury is at a huge disadvantage and will likely overpay. Moreover, there will have to be many auctions of very different securities. All of this will take months to execute.
Reportedly, thought is now being given to only buying "bad assets" and putting them in a fund (called a "bad bank") owned by the government. This new variation raises additional problems. First, how should "bad assets" be defined? As the recession deepens, bad assets have multiplied and will continue to multiply from mortgages and mortgage-related securities to many other assets classes, including credit-card portfolios. We see little sense in defining bad assets simply as those that have been already significantly written down. The bank may be more exposed to losses from assets that have not been significantly written down, but could well be.
Further, as the potential class of bad assets expands so does the cost of purchase. Total mortgage-related securities and mortgages held by banks alone are estimated to be $6 trillion, of which mortgage-backed securities are $1.3 trillion. Total bank assets are $16.5 trillion.
Another proposal is to guarantee the value of bad assets rather than buy them. This outcome could be accomplished by a direct guarantee of assets that remained on the balance sheet of banks (or were brought in from outside conduits or SIVs), or into one government-run bad bank.
A version of this approach was used in the second round of TARP financing for Citigroup and Bank of America. In the case of Citigroup, a $306 billion asset pool was created in which Citigroup absorbs the first $29 billion of losses, the Treasury and FDIC jointly fund 90% of the next $15 billion ($5 billion from the Treasury through TARP, and $10 billion from the FDIC), and the Fed finally funds 90% of the remaining losses. In return, the government received $7 billion in preferred stock (with an 8% yield) -- $4 billion to Treasury, $3 billion to FDIC. Under this approach, the problem of valuing the assets has been finessed into a problem of valuing the stock.
With more transparency, which Congress and its Oversight Panel would surely demand, that finesse would not work. A conservative estimate puts the value of the Citigroup option -- i.e., the potential cost to taxpayers -- at $60 billion, taking account of the stock warrants the government received. If one were to repeat this approach for all banks the cost would be as much as TARP. And, if the market for toxic assets were to fall further, the government could easily be responsible for trillions of dollars of losses. Last but not least, having the Fed become the residual risk bearer further undermines the Fed's financial stability and its ultimate independence, a concern recently voiced by the Committee on Capital Markets Regulation.
A more reasonable alternative would be to encourage banks to spin off the toxic assets into separate affiliated bad banks (as under a new reported German initiative). Ownership of these two entities would be allocated pro rata to all the financial investors as a proportion of the most updated accounting value of these assets. So a bank with $30 billion of bad assets and $70 billion of good assets will see its debt divided 30%-70% and its equity divided 30%-70%. Each $100 debt claim will become a $30 debt claim in the bad bank and a $70 debt claim in the good bank. The same would be true for equity. To limit the exposure of the FDIC to the bad bank, insured deposits and FDIC-guaranteed debt should remain in the good bank to the extent there are sufficient matching good assets. In addition, off-balance-sheet derivative contracts remain off balance sheet for the good bank to avoid the possibility that the failure of the bad bank would create systemic risk. Furthermore, convincing evidence would be needed before guaranteeing any of the liabilities of a bad bank because ordinarily a bad-bank failure should not result in systemic risk.
An alternative would be for the government to facilitate the injection of new, private-equity capital into banks by eliminating regulatory restrictions, such as bank ownership by private-equity or commercial firms, and providing protection against loss or dilution if there were to be subsequent government intervention. A subsidy for this private risk capital could even be given. As long as private capital holds most of the risk, it will certainly be allocated more efficiently than government money, minimizing the taxpayer cost of any subsidy. This idea would have to be more fully explored.
Whatever is done with respect to still solvent institutions, banks with dangerously low, or no or negative capital, should be taken over by the government through already established FDIC procedures, such as bridge loans. Just as with the Savings and Loan crisis of the 1980s, there is a significant risk that shareholders (and managers) with nothing to lose will roll the dice and lose even more. Existing shareholders with no equity should not benefit by government support. Further, a government takeover (just like a corporate bankruptcy) permits the restructuring of bank debt. As the S&L debacle shows, a decision worse than a nationalization of the banking sector is a nationalization of the losses, which still leaves the gains in private hands.
With still solvent institutions, there is no affordable and workable plan that will by itself assure that these banks will start lending and that private capital will return. We have stabilized the financial system against massive collapse, which is probably all the government can do. While we hope some more improvement may come from the bad bank or private-equity solutions outlined above, the road to further recovery of the financial system now lies principally with the economy's recovery and the success of the fiscal stimulus.
When Henry Paulson, President Bush's Treasury secretary, first introduced the Troubled Asset Relief Program (TARP) in Congress last September, we cautioned against using government funds to buy mortgages and mortgage-related securities from banks. After the Emergency Economic Stabilization Act was signed into law in early October, the Treasury decided not to buy these assets. Instead, it used the first $350 billion of TARP funds to inject capital first into nine systemically important troubled banks, and later into insurer AIG (as part of a refinancing) and auto makers General Motors and Chrysler.
This approach seems to have achieved (albeit at a high cost for taxpayers) its principal objective of avoiding a massive collapse of the financial system. But it has not yet resulted in an increase in bank lending or the attraction of new private equity to the banking system, both of which are important to reviving the economy. There now appears to be active consideration of using TARP funds to buy "bad assets" from the banks. Major problems with so doing remain.
The central issue is how to price the assets. When the subprime crisis hit in the summer of 2007, the Treasury's first response was to encourage the private sector to create a fund -- the so-called Super SIV (structured investment vehicle) -- to buy mortgage-related assets. This proposal foundered due to the difficulty of setting a price for these assets, which come in complex and incomparable varieties. If Treasury pays close to par, it is paying far too much. If it pays current prices, no one will sell because of the adverse impact on their capital. If it pulls a price out of a hat, it will be acting arbitrarily.
Initial discussions focused on using a reverse auction with asset holders "bidding" to sell their mortgage-related securities to the Treasury. Such an approach raises significant problems -- most significant is the risk posed by asymmetric information regarding the value of these securities. Because the holders of complex and incomparable mortgage-related securities have more information regarding their worth than does Treasury, Treasury is at a huge disadvantage and will likely overpay. Moreover, there will have to be many auctions of very different securities. All of this will take months to execute.
Reportedly, thought is now being given to only buying "bad assets" and putting them in a fund (called a "bad bank") owned by the government. This new variation raises additional problems. First, how should "bad assets" be defined? As the recession deepens, bad assets have multiplied and will continue to multiply from mortgages and mortgage-related securities to many other assets classes, including credit-card portfolios. We see little sense in defining bad assets simply as those that have been already significantly written down. The bank may be more exposed to losses from assets that have not been significantly written down, but could well be.
Further, as the potential class of bad assets expands so does the cost of purchase. Total mortgage-related securities and mortgages held by banks alone are estimated to be $6 trillion, of which mortgage-backed securities are $1.3 trillion. Total bank assets are $16.5 trillion.
Another proposal is to guarantee the value of bad assets rather than buy them. This outcome could be accomplished by a direct guarantee of assets that remained on the balance sheet of banks (or were brought in from outside conduits or SIVs), or into one government-run bad bank.
A version of this approach was used in the second round of TARP financing for Citigroup and Bank of America. In the case of Citigroup, a $306 billion asset pool was created in which Citigroup absorbs the first $29 billion of losses, the Treasury and FDIC jointly fund 90% of the next $15 billion ($5 billion from the Treasury through TARP, and $10 billion from the FDIC), and the Fed finally funds 90% of the remaining losses. In return, the government received $7 billion in preferred stock (with an 8% yield) -- $4 billion to Treasury, $3 billion to FDIC. Under this approach, the problem of valuing the assets has been finessed into a problem of valuing the stock.
With more transparency, which Congress and its Oversight Panel would surely demand, that finesse would not work. A conservative estimate puts the value of the Citigroup option -- i.e., the potential cost to taxpayers -- at $60 billion, taking account of the stock warrants the government received. If one were to repeat this approach for all banks the cost would be as much as TARP. And, if the market for toxic assets were to fall further, the government could easily be responsible for trillions of dollars of losses. Last but not least, having the Fed become the residual risk bearer further undermines the Fed's financial stability and its ultimate independence, a concern recently voiced by the Committee on Capital Markets Regulation.
A more reasonable alternative would be to encourage banks to spin off the toxic assets into separate affiliated bad banks (as under a new reported German initiative). Ownership of these two entities would be allocated pro rata to all the financial investors as a proportion of the most updated accounting value of these assets. So a bank with $30 billion of bad assets and $70 billion of good assets will see its debt divided 30%-70% and its equity divided 30%-70%. Each $100 debt claim will become a $30 debt claim in the bad bank and a $70 debt claim in the good bank. The same would be true for equity. To limit the exposure of the FDIC to the bad bank, insured deposits and FDIC-guaranteed debt should remain in the good bank to the extent there are sufficient matching good assets. In addition, off-balance-sheet derivative contracts remain off balance sheet for the good bank to avoid the possibility that the failure of the bad bank would create systemic risk. Furthermore, convincing evidence would be needed before guaranteeing any of the liabilities of a bad bank because ordinarily a bad-bank failure should not result in systemic risk.
An alternative would be for the government to facilitate the injection of new, private-equity capital into banks by eliminating regulatory restrictions, such as bank ownership by private-equity or commercial firms, and providing protection against loss or dilution if there were to be subsequent government intervention. A subsidy for this private risk capital could even be given. As long as private capital holds most of the risk, it will certainly be allocated more efficiently than government money, minimizing the taxpayer cost of any subsidy. This idea would have to be more fully explored.
Whatever is done with respect to still solvent institutions, banks with dangerously low, or no or negative capital, should be taken over by the government through already established FDIC procedures, such as bridge loans. Just as with the Savings and Loan crisis of the 1980s, there is a significant risk that shareholders (and managers) with nothing to lose will roll the dice and lose even more. Existing shareholders with no equity should not benefit by government support. Further, a government takeover (just like a corporate bankruptcy) permits the restructuring of bank debt. As the S&L debacle shows, a decision worse than a nationalization of the banking sector is a nationalization of the losses, which still leaves the gains in private hands.
With still solvent institutions, there is no affordable and workable plan that will by itself assure that these banks will start lending and that private capital will return. We have stabilized the financial system against massive collapse, which is probably all the government can do. While we hope some more improvement may come from the bad bank or private-equity solutions outlined above, the road to further recovery of the financial system now lies principally with the economy's recovery and the success of the fiscal stimulus.
The weekend that Wall Street died
Source: WSJ
Lehman Brothers Holdings Inc. Chief Executive Richard S. Fuld Jr., wearing tie, is heckled by protesters in October as he leaves Capitol Hill in Washington after testify before the House Oversight and Government Reform Committee on the collapse of Lehman Brothers.
With his investment bank facing a near-certain failure, Lehman Brothers Holdings Inc.'s chief executive officer, Richard Fuld Jr., placed yet another phone call to the man he thought could save him.
Fuld was already effectively out of options by the afternoon of Sunday, Sept. 14. The U.S. government said it wouldn't fund a bailout for Lehman, the country's oldest investment bank. Britain's Barclays PLC had agreed in principle to buy the loss-wracked firm, but the deal fell apart. Bank of America Corp., initially seen as Lehman's most likely buyer, had said two days earlier that it couldn't do a deal without federal aid -- and by Sunday was deep in secret negotiations to take over Lehman rival Merrill Lynch & Co.
Desperate to avoid steering his 25,000-person company into bankruptcy proceedings, Fuld dialed the Charlotte, N.C., home of Bank of America Chairman Kenneth D. Lewis. His calls so far that weekend had gone unreturned. This time, Lewis's wife, Donna, again picked up, and told the boss of Lehman Brothers: If Lewis wanted to call back, he would call back.
Fuld paused, then apologized for bothering her. "I am so sorry," he said.
Associated Press File Merrill Lynch Chairman and CEO John Thain, left, and Bank of America Chairman and CEO Ken Lewis shake hands following a news conference in New York.
His lament could also have been for the investment-banking model that had come to embody the words "Wall Street." Within hours of his call, Lehman announced it would file for bankruptcy protection. Within a week, Wall Street as it was known -- loosely regulated, daringly risky and lavishly rewarded -- was dead.
As Fuld waged his increasingly desperate bid to save his firm that weekend, the bosses of Wall Street's other three giant investment banks were locked in their own battles as their firms came under mounting pressure. It was a weekend unlike anything Wall Street had ever seen: In past crises, its bosses had banded together to save their way of life. This time, the financial hole they had dug for themselves was too deep. It was every man for himself, and Fuld, who declined to comment for this article, was the odd man out.
For the U.S. securities industry to unravel as spectacularly as it did in September, many parties had to pull on many threads. Mortgage bankers gave loans to Americans for homes they couldn't afford. Investment houses packaged these loans into complex instruments whose risk they didn't always understand. Ratings agencies often gave their seal of approval, investors borrowed heavily to buy, regulators missed the warning signs. But at the center of it all -- and paid hundreds of millions of dollars during the boom to manage their firms' risk -- were the four bosses of Wall Street.
Details of these CEOs' decisions and negotiations, many of them previously unreported, show how they sought to avert the death of America's giant investment banks. Their efforts culminated in a round-the-clock weekend of secret negotiations and personal struggles to keep their firms afloat. Accounts of these events are based on company and other documents, emails and interviews with Wall Street executives, traders, regulators, investors and others.
Summer Clouds
Earlier this year, when the financial crisis claimed its first victim, Bear Stearns Cos., the surviving masters of Wall Street thought the eye of the storm had passed. Bear Stearns, the smallest of Wall Street's big five stand-alone investment banks, imploded just months after bad subprime bets sunk two internal hedge funds. In March 2008, the government brokered Bear Stearns's sale to J.P. Morgan Chase & Co.
After Bear Stearns's brush with death, the Federal Reserve for the first time allowed investment houses to borrow from the government on much the same terms as commercial banks. Many on Wall Street saw investment banks' access to an equivalent of the Fed "discount window" as a blank check should hard times return. But it would also be the first step in giving the government more say over an industry that had until then been lightly regulated.
Associated Press File Lloyd C. Blankfein, of Goldman Sachs,
In April, Morgan Stanley's CEO, John Mack, told shareholders the U.S. subprime crisis was in the eighth or ninth inning. The same month, Goldman Sachs Group Inc.'s chief executive, Lloyd Blankfein, said, "We're probably in the third or fourth quarter" of a four-quarter game.
Mack and Blankfein had some reason to be confident. Mack had been late to steer Morgan into mortgage trading, and relatively early to sell assets and raise cash. Goldman, under Blankfein, had even less direct exposure to subprime investments. Blankfein also took comfort in a stockpile of government bonds and other securities his firm held in case it ran into deep funding problems. By the second quarter, Goldman had increased this store of funds more than 30 percent from earlier in the year, to $88 billion.
Problems were more acute at Merrill Lynch and Lehman.
John Thain, a former Goldman Sachs president and New York Stock Exchange head, had arrived at Merrill Lynch in December 2007. He moved quickly to cut costs, putting the corporate helicopter up for sale and replacing the fresh flowers on a Merrill floor used by nine or so executives -- an estimated annual expense of $200,000 -- with fakes
More monumentally, Thain faced $55 billion in soured mortgage assets that Merrill had acquired under his predecessor. Within weeks of his arrival, he had raised more than $12 billion in much-needed capital, including $5 billion from Singapore's state investment company, Temasek Holdings, at $48 a share.
Some of those early deals would end up being costly. With his would-be investors driving a hard bargain, Thain promised Temasek and others that if Merrill sold additional common stock at a lower price within a year, the firm would compensate them. Within months, after taking a big write-down on a portfolio of mortgage debts that Merrill sold for pennies on the dollar, the firm had to raise more cash at $25 a share. Merrill issued additional shares to pay off its earlier investors, diluting its common shares by 39 percent. The dilution essentially cost shareholders about $5 billion, well above the previously reported $2.5 billion cost of shares issued to Temasek.
Lehman, now the smallest of the major Wall Street firms, also faced billions of dollars in write-downs from bad mortgage-related investments. In June, Lehman reported the first quarterly loss in its 14 years as a public company. Under Fuld, Lehman raised capital. But critics say Fuld was slow to shed bad assets and profitable lines of business. He pushed for better terms with at least one investor that ended up driving it away.
Fuld had faced challenges to his firm before. Since taking Lehman's reins in 1994, he expanded the 158-year-old bond house into lucrative areas such as investment banking and stock trading. Over the years, he had tamped unfounded rumors about the firm's health and vowed to remain independent. "As long as I am alive this firm will never be sold," Fuld said in December 2007, according to a person who spoke with him then. "And if it is sold after I die, I will reach back from the grave and prevent it."
In the summer of 2008, Fuld remained confident, particularly given the security of the Fed's discount window. "We have access to Fed funds," Fuld told executives at the time. "We can't fail now."
Friday, Sept. 12
By Friday, Sept. 12, failure appeared to be an option for Lehman.
Over that week, confidence in Lehman plunged. The firm said its third-quarter losses could total almost $4 billion. Lehman's clearing bank, J.P. Morgan, wanted an extra $5 billion in collateral. Lehman's attempts to raise money from a Korean bank had stalled. Credit agencies were warning that if Lehman didn't raise more capital over the weekend, it could face a downgrade. That would likely force the firm to put up more collateral for its outstanding loans and increase its costs for new loans.
If Fuld couldn't find an investor for Lehman by Sunday night, the fiercely independent boss could be forced to steer his firm into bankruptcy proceedings.
Earlier that week, Fuld had approached Bank of America's Lewis about buying Lehman. A U.S. Treasury official, meanwhile, had contacted Barclays of Britain to suggest it consider taking a stake in Lehman. Fuld's top executives spent Friday shuttling between the two suitors' law firms.
Lehman was also exploring a third option: The night before, veteran bankruptcy lawyer Harvey Miller of Weil, Gotshal & Manges had secretly begun cobbling together a bare-bones bankruptcy filing for the firm.
Lehman's troubles were putting the rest of Wall Street on notice.
In a Merrill Lynch conference room in downtown Manhattan that morning, Thain was on a call with Merrill's board of directors, discussing how to address the chaos. "Lehman is going down, and the [short sellers] are coming after us next," warned Merrill director John Finnegan. "Tell me how this story is going to end differently."
Merrill would be fine, Thain said. "We are not Lehman," he responded, noting the firm held valuable assets, including its stake in BlackRock, a profitable asset-management firm.
But Merrill's clients, too, were beginning to pull out money. The firm's stock was sinking. Executives, including Merrill President Gregory Fleming, were nervous.
Fleming believed he'd identified the ideal partner for Merrill. Bank of America, with a strong balance sheet and retail operations, would mesh well with Merrill's securities franchise and 16,000-strong brokerage force. Fleming worried that Bank of America could buy Lehman instead.
Fleming called a long-time lawyer for Bank of America, Edward Herlihy of Wachtell, Lipton, Rosen & Katz. "You have to talk to us," Fleming said. He was told that Merrill's Thain would have to approach Bank of America's Lewis. "I know," Fleming responded. "I'm gonna try."
At 5 p.m. Friday, after a day of massive client withdrawals at Lehman, Thain's phone rang. It was the Treasury. "Be at the Fed at 6 p.m.," Thain was told.
Soon after, Thain gathered along with Morgan's Mack and Goldman's Blankfein at the New York Federal Reserve in downtown Manhattan, in a room once used to cash coupons on Treasury bills. The three men were greeted by the masters of the world's biggest economy -- Federal Reserve Chairman Ben Bernanke, Treasury Secretary Henry Paulson, New York Fed Chief Timothy Geithner and Securities and Exchange Commission chief Christopher Cox. It was a signal moment for the Wall Street firms, which after years of being monitored by the SEC would all soon come under the regulatory watch of a newly powerful Fed.
The federal officials told the Wall Street chiefs to return in the morning. If the mess at Lehman could be fixed, it would be the job of the Wall Street bosses. There would be no public bailout.
An industry-led solution wouldn't be without precedent. In the market panic of 1907, financier J.P. Morgan persuaded fellow bankers to help fund a bailout for failing rivals. Competitors united again in 1998, putting up money to insulate the financial system from the failure of hedge fund Long Term Capital Management.
But now, Fuld's problems at Lehman were possibly beyond repair.
By that night, Bank of America's team had concluded that Lehman's real-estate portfolio was worse than expected -- and as a result, the firm's liabilities likely exceeded its assets. "We need government assistance, and we are not getting it," the bank's top deal maker, Greg Curl, told his group. Some of the negotiators prepared to fly back early the next morning to headquarters in Charlotte.
Lewis hadn't come to New York for the Lehman talks. He called Fuld from Charlotte, telling him that Bank of America couldn't do a deal without federal help. "We will keep a team in New York in case things change," Lewis told him.
Saturday, Sept. 13
Fuld arrived at Lehman's office at 7 a.m. on Saturday, wearing a blue suit and tie. The talks with Barclays were still moving. If the government could be moved, there could also be hope for a Bank of America deal.
Merrill, meanwhile, was beginning its own pursuit of Bank of America.
At his home in Rye, N.Y., Thain was getting dressed for a day at the New York Fed when his phone rang. It was Merrill's president, Fleming.
"John, you really need to call Ken Lewis," Fleming said.
"Get me his number," said Thain, who added it to his papers for the day.
Thain's black SUV pulled up in front of the New York Fed just before 8 a.m. Top executives from all four investment banks -- minus Lehman's Fuld -- were there.
Federal officials broke Thain, Mack and Blankfein and their top aides into groups. One studied the potential fallout from a Lehman failure. Another was charged with putting a value on Lehman's controversial real-estate investments. A third group, which included Thain and Morgan's Mack, was supposed to discuss an industry-led bailout for Lehman.
Lehman's president, Bart McDade, walked the group through the embattled firm's books. McDade did not respond to requests for comment for this article.
Mack questioned Wall Street's ability to repair markets. The firms could try to backstop Lehman, he argued, but there was no guarantee they wouldn't have to rescue another rival later. "If we're going to do this deal, where does it end?" he said.
As McDade discussed Lehman's position, Thain had an epiphany: "This could be me sitting here next Friday."
Thain pushed his chair back and left the group to caucus with top Merrill officers. "Lehman is not going to make it," he told them.
Thain stepped to a sidewalk behind the New York Fed and called the Bank of America chief at his home in Charlotte. "I can be there in a few hours," Lewis said.
Members of Bank of America's deal team, exhausted from scrutinizing Lehman's books, had just landed in Charlotte. Lewis ordered them back to New York.
Up in Lehman's midtown office, Fuld was also dialing Lewis's North Carolina home. His calls went unreturned. "I can't believe that son of a bitch won't return my calls," he told a top adviser.
Lehman's bankruptcy team, meanwhile, was rolling into action. Shortly before noon, Miller, the Weil Gotshal bankruptcy head, sent an email to several partners. Lehman's name didn't appear in the email. Its subject line read: "Urgent. Code name: Equinox. Have desperate need for help on an emergency situation."
Throughout the day, Miller's attorneys, working with Federal Reserve officials and their attorneys, began seeking information from Lehman. But with Lehman's top officials tied up at the Fed and in Barclays negotiations, the lawyers were hard-pressed to get the details they needed.
"We were a distraction to the Lehman people," said Lori Fife, a Weil partner. "It felt like it was just a fire drill."
Later that afternoon, Merrill's chief executive met Bank of America's CEO, Lewis, in the bank's corporate apartment in the Time Warner Center. In a one-on-one meeting overlooking Central Park, the two men agreed that it looked like Lehman would be forced into bankruptcy.
Thain made his opening offer. "How about buying a 9.9 percent stake" in Merrill, he proposed.
Lewis said the bank doesn't tend to buy minority stakes. He suggested Bank of America could buy the whole firm.
"I am not here to sell Merrill Lynch," Thain responded.
"Well, that is what I want," Lewis countered.
The two parted with an agreement to keep talking.
Lehman's talks with Barclays, meanwhile, were moving forward at the New York Fed, under the eye of government officials. "Shouldn't I be there?" Fuld said to Lehman President Mr. McDade and to attorney Rodgin Cohen of Sullivan & Cromwell LLP, a longtime adviser.
What Fuld appeared not to know was that some top government officials had instructed key Lehman representatives at the Fed building to keep Fuld away that weekend. The federal officials had explained that Fuld -- not only Wall Street's longest-serving boss, but a director of the New York Fed -- could be an unnecessary distraction and a lightning rod for criticism.
At the Fed meetings, much of the talk was on the sidelines. When Thain returned to the New York Fed from his discussions with Lewis, Merrill advisers told him they had been approached by top Goldman executives. The rival house was interested in taking a 9.9 percent stake in Merrill and offered to extend a $10 billion line of credit.
Thain was digesting the news when he was approached by Mack of Morgan Stanley. "We should talk," Mack said. The bosses of Merrill and Morgan agreed to meet that evening. Soon, Thain and two advisers were en route to the Upper East Side apartment of a Morgan co-president.
Thain drank a Diet Coke as the Morgan and Merrill executives talked. Both sides felt there were benefits to merging. Thain indicated he needed a deal quickly. The meeting ended without a firm plan. "We have a board meeting Tuesday and can get back to you soon," Mack said before the group broke up.
As Thain and his advisers left the apartment, the Merrill chief suggested he had faint hopes for a deal with Morgan Stanley. "I don't think they share our sense of urgency," he said.
Merrill's talks with Bank of America, however, were on track at the bank's law firm, Wachtell Lipton. Merrill's team was camped out on Wachtell's 34th floor. Bank of America's team was on the 33rd. Around midnight, Lewis left the law firm for his apartment in the Time Warner Center. Pizza arrived at Wachtell at 3 a.m.
At Lehman's offices that evening, Fuld still hadn't heard back from Lewis. Attorneys from Weil were poring through documents, drawing up what would be the largest bankruptcy in U.S. history.
But in a rare piece of good news for Lehman, Barclays had agreed to buy Lehman, as long as it didn't have to take on its soured real-estate assets. Lehman's asset-management division would also be spun off. The Fed indicated that a syndicate of banks and brokers had agreed in principle to put up enough capital to support a separate company that would hold Lehman's bad real-estate assets.
Sunday, Sept. 14
A few hours later, at 8 a.m., Thain arrived at the Time Warner Center for a second one-on-one meeting in Lewis's corporate apartment. Over coffee, Thain made his case for a strong price for Merrill despite its stock's recent fall.
At the same time, Merrill officials were huddled with Goldman bankers. Some members of Merrill's team doubted that Goldman could save their firm by taking a 9.9 percent stake. Pete Kelly, a top Merrill lawyer, also had his reservations about letting rival Goldman see his firm's books. Still, the sides set a late-morning meeting at Merrill's offices.
At 9 a.m., the chiefs of finance arrived again at the New York Fed for a second day of meetings. By the time Thain arrived, the Merrill chief had a number of options in his back pocket.
Rolling up to the meetings at around the same time was Goldman's chief, Blankfein. A Goldman aide, referring to days of meltdowns and meetings, carped to Blankfein: "I don't think I can take another day of this."
Blankfein retorted: "You're getting out of a Mercedes to go to the New York Federal Reserve -- you're not getting out of a Higgins boat on Omaha Beach," he said, referring to the World War II experience of a former Goldman head. "So keep things in perspective."
At Lehman that morning, Fuld told his board of directors to gather at the firm's offices. By noon, he expected, the board would be able to approve Lehman's sale to Barclays.
One hurdle remained: To ink a Lehman deal, Barclays needed a shareholder vote. There was no way to get one on a Sunday. Barclays would need the U.S. or British government to back Lehman's trading balances until a vote could be held.
Government approval never came, though there are diverging views on why. Some blame the U.S. government for refusing to commit resources. Others say the British government refused to entertain a deal they worried would expose England to unnecessary risk.
Lehman's president, McDade, and Cohen, the attorney, called Fuld from the New York Fed. Passing McDade's cellphone back and forth, they broke the Barclays news.
Fuld postponed his board meeting. He made one more call to Charlotte, answered by Lewis's wife.
By midafternoon, word emerged that Bank of America was in talks with Merrill Lynch. Cohen, the attorney, broke the news to Fuld. "I guess this confirms our worst fears," Fuld said.
At the Fed, the Lehman executives and their bankruptcy attorneys faced roughly 25 officials from the Fed, Treasury and SEC. The Lehman officials pleaded for federal aid to keep Lehman afloat. But with Barclays and Bank of America off the table, Federal officials wanted a plan in place to soothe markets before trading opened in Asia.
A senior Fed official asked Miller, the Weil veteran who'd been involved in bankruptcy filings of companies including Bethlehem Steel and Marvel Entertainment, if Lehman was ready to file.
"No," Miller answered.
"You need more of a plan to prepare to do this," Miller continued. Lehman had tens of billions of dollars in derivative positions with countless parties. Unless these trades were unwound in an orderly way, it could shock all corners of the financial market. "This will cause financial Armageddon," he said.
Now, Merrill's Thain needed his own deal more than ever. With a Morgan tie-up looking like a long shot, Merrill focused its attentions on Goldman and Bank of America.
Tempers at Merrill flared as two rival teams pored over the firm's records. Merrill's head of strategy Peter Kraus, a Goldman alumnus hired by Thain, wanted to pull some of the firm's due-diligence staff away from the Bank of America project to look at Goldman's offer. "We need some people down here," Kraus said.
"We have a great deal in hand, and need to finish doing this deal," retorted Fleming, Merrill's president. A few minutes later, Thain called Fleming, telling him to send some people to work on the Goldman offer.
Fleming and Bank of America's lead negotiator, Curl, hammered out a price. Bank of America would buy Merrill for $29 a share.
Fleming informed Thain. At 6 p.m., Merrill's top managers and directors gathered in person and by phone.
"When I took this job this was not the outcome I intended," Thain told directors. After the board meeting broke up after 8 p.m., Thain called the chief of Bank of America. "The decision was unanimous," Thain told Mr. Lewis. "You have a deal."
A more somber scene was playing out at Lehman. Directors, who had been camped at the Midtown offices all day, gathered at around 8 p.m. in the firm's board room. Weil lawyers and Lehman executives summarized the Fed meeting to the frustrated board.
"They bailed out Bear," said Roland Hernandez, the former CEO of Spanish-language TV network Telemundo and a longtime Lehman board member. "Why not us?"
One of Fuld's assistants broke in to hand him a note: The SEC chairman wanted to address Lehman's board by speakerphone.
Cox, criticized for his allegedly minor role in the government's bailout of Bear Stearns, had been reluctant to call Lehman. The SEC chief finally called from the New York Fed, surrounded by several staffers, at the urging of Mr. Paulson, the Treasury secretary.
"This is serious," said Cox. "The board has a grave matter before it," he said.
John D. McComber, a former president of the Export-Import Bank and a Lehman director for 14 years, asked: "Are you directing us to authorize" a bankruptcy filing?
The SEC chief muted his phone. A minute later, he came back on the line. "You have a grave responsibility and you need to act accordingly," he replied.
As the meeting wrapped up around 10 p.m., Fuld, his suit jacket now off, leaned back in his chair. "I guess this is goodbye," he said. Lehman would file about four hours later.
Just a few blocks away, Merrill and Bank of America executives met to toast their deal. "I look forward to a great partnership with Merrill Lynch," Lewis said around midnight, a glass of champagne in hand.
The End
Rather than soothing markets, Lehman's bankruptcy filing roiled them -- slamming trading partners that had direct exposure to the firm and sowing fears that Wall Street's remaining giants weren't safe from failure. Shares of Morgan and Goldman plunged. In the credit-default swap market, the price of insurance against defaults of Morgan and Goldman soared.
Hedge funds sought to withdraw more than $100 billion in assets from Morgan Stanley. The firm's clearing bank, Bank of New York Mellon, wanted an extra $4 billion in collateral.
Morgan's chief, Mr. Mack, negotiated a cash infusion from Japan's Mitsubishi UFJ Financial Group. Fed and Treasury officials, concerned that a deal could be derailed by a declining Morgan share price, asked if Mack had other options. One regulator suggested Morgan Stanley consider selling itself to J.P. Morgan -- from which it had been famously split, 73 years earlier, amid post-Depression banking reform laws.
"We're going to get Mitsubishi done. There is no Plan B," Mack told one regulator.
Morgan did the deal. But investor fears remained. By Thursday, Fed officials were urging Morgan to become a commercial bank. Such a move would require Morgan to scale back its bets with borrowed money, run the risk of selling lucrative business lines and accept new onsite regulation from the Fed.
Mack consented, and the following weekend, Morgan Stanley formally ceased to be a securities firm.
The same weekend, Blankfein convened top lieutenants on his 30th-floor office. After 139 years as a securities firm, he said, Goldman, too, would also reshape itself as a commercial bank. Within hours, the era of Wall Street's giants was over.
Lehman Brothers Holdings Inc. Chief Executive Richard S. Fuld Jr., wearing tie, is heckled by protesters in October as he leaves Capitol Hill in Washington after testify before the House Oversight and Government Reform Committee on the collapse of Lehman Brothers.
With his investment bank facing a near-certain failure, Lehman Brothers Holdings Inc.'s chief executive officer, Richard Fuld Jr., placed yet another phone call to the man he thought could save him.
Fuld was already effectively out of options by the afternoon of Sunday, Sept. 14. The U.S. government said it wouldn't fund a bailout for Lehman, the country's oldest investment bank. Britain's Barclays PLC had agreed in principle to buy the loss-wracked firm, but the deal fell apart. Bank of America Corp., initially seen as Lehman's most likely buyer, had said two days earlier that it couldn't do a deal without federal aid -- and by Sunday was deep in secret negotiations to take over Lehman rival Merrill Lynch & Co.
Desperate to avoid steering his 25,000-person company into bankruptcy proceedings, Fuld dialed the Charlotte, N.C., home of Bank of America Chairman Kenneth D. Lewis. His calls so far that weekend had gone unreturned. This time, Lewis's wife, Donna, again picked up, and told the boss of Lehman Brothers: If Lewis wanted to call back, he would call back.
Fuld paused, then apologized for bothering her. "I am so sorry," he said.
Associated Press File Merrill Lynch Chairman and CEO John Thain, left, and Bank of America Chairman and CEO Ken Lewis shake hands following a news conference in New York.
His lament could also have been for the investment-banking model that had come to embody the words "Wall Street." Within hours of his call, Lehman announced it would file for bankruptcy protection. Within a week, Wall Street as it was known -- loosely regulated, daringly risky and lavishly rewarded -- was dead.
As Fuld waged his increasingly desperate bid to save his firm that weekend, the bosses of Wall Street's other three giant investment banks were locked in their own battles as their firms came under mounting pressure. It was a weekend unlike anything Wall Street had ever seen: In past crises, its bosses had banded together to save their way of life. This time, the financial hole they had dug for themselves was too deep. It was every man for himself, and Fuld, who declined to comment for this article, was the odd man out.
For the U.S. securities industry to unravel as spectacularly as it did in September, many parties had to pull on many threads. Mortgage bankers gave loans to Americans for homes they couldn't afford. Investment houses packaged these loans into complex instruments whose risk they didn't always understand. Ratings agencies often gave their seal of approval, investors borrowed heavily to buy, regulators missed the warning signs. But at the center of it all -- and paid hundreds of millions of dollars during the boom to manage their firms' risk -- were the four bosses of Wall Street.
Details of these CEOs' decisions and negotiations, many of them previously unreported, show how they sought to avert the death of America's giant investment banks. Their efforts culminated in a round-the-clock weekend of secret negotiations and personal struggles to keep their firms afloat. Accounts of these events are based on company and other documents, emails and interviews with Wall Street executives, traders, regulators, investors and others.
Summer Clouds
Earlier this year, when the financial crisis claimed its first victim, Bear Stearns Cos., the surviving masters of Wall Street thought the eye of the storm had passed. Bear Stearns, the smallest of Wall Street's big five stand-alone investment banks, imploded just months after bad subprime bets sunk two internal hedge funds. In March 2008, the government brokered Bear Stearns's sale to J.P. Morgan Chase & Co.
After Bear Stearns's brush with death, the Federal Reserve for the first time allowed investment houses to borrow from the government on much the same terms as commercial banks. Many on Wall Street saw investment banks' access to an equivalent of the Fed "discount window" as a blank check should hard times return. But it would also be the first step in giving the government more say over an industry that had until then been lightly regulated.
Associated Press File Lloyd C. Blankfein, of Goldman Sachs,
In April, Morgan Stanley's CEO, John Mack, told shareholders the U.S. subprime crisis was in the eighth or ninth inning. The same month, Goldman Sachs Group Inc.'s chief executive, Lloyd Blankfein, said, "We're probably in the third or fourth quarter" of a four-quarter game.
Mack and Blankfein had some reason to be confident. Mack had been late to steer Morgan into mortgage trading, and relatively early to sell assets and raise cash. Goldman, under Blankfein, had even less direct exposure to subprime investments. Blankfein also took comfort in a stockpile of government bonds and other securities his firm held in case it ran into deep funding problems. By the second quarter, Goldman had increased this store of funds more than 30 percent from earlier in the year, to $88 billion.
Problems were more acute at Merrill Lynch and Lehman.
John Thain, a former Goldman Sachs president and New York Stock Exchange head, had arrived at Merrill Lynch in December 2007. He moved quickly to cut costs, putting the corporate helicopter up for sale and replacing the fresh flowers on a Merrill floor used by nine or so executives -- an estimated annual expense of $200,000 -- with fakes
More monumentally, Thain faced $55 billion in soured mortgage assets that Merrill had acquired under his predecessor. Within weeks of his arrival, he had raised more than $12 billion in much-needed capital, including $5 billion from Singapore's state investment company, Temasek Holdings, at $48 a share.
Some of those early deals would end up being costly. With his would-be investors driving a hard bargain, Thain promised Temasek and others that if Merrill sold additional common stock at a lower price within a year, the firm would compensate them. Within months, after taking a big write-down on a portfolio of mortgage debts that Merrill sold for pennies on the dollar, the firm had to raise more cash at $25 a share. Merrill issued additional shares to pay off its earlier investors, diluting its common shares by 39 percent. The dilution essentially cost shareholders about $5 billion, well above the previously reported $2.5 billion cost of shares issued to Temasek.
Lehman, now the smallest of the major Wall Street firms, also faced billions of dollars in write-downs from bad mortgage-related investments. In June, Lehman reported the first quarterly loss in its 14 years as a public company. Under Fuld, Lehman raised capital. But critics say Fuld was slow to shed bad assets and profitable lines of business. He pushed for better terms with at least one investor that ended up driving it away.
Fuld had faced challenges to his firm before. Since taking Lehman's reins in 1994, he expanded the 158-year-old bond house into lucrative areas such as investment banking and stock trading. Over the years, he had tamped unfounded rumors about the firm's health and vowed to remain independent. "As long as I am alive this firm will never be sold," Fuld said in December 2007, according to a person who spoke with him then. "And if it is sold after I die, I will reach back from the grave and prevent it."
In the summer of 2008, Fuld remained confident, particularly given the security of the Fed's discount window. "We have access to Fed funds," Fuld told executives at the time. "We can't fail now."
Friday, Sept. 12
By Friday, Sept. 12, failure appeared to be an option for Lehman.
Over that week, confidence in Lehman plunged. The firm said its third-quarter losses could total almost $4 billion. Lehman's clearing bank, J.P. Morgan, wanted an extra $5 billion in collateral. Lehman's attempts to raise money from a Korean bank had stalled. Credit agencies were warning that if Lehman didn't raise more capital over the weekend, it could face a downgrade. That would likely force the firm to put up more collateral for its outstanding loans and increase its costs for new loans.
If Fuld couldn't find an investor for Lehman by Sunday night, the fiercely independent boss could be forced to steer his firm into bankruptcy proceedings.
Earlier that week, Fuld had approached Bank of America's Lewis about buying Lehman. A U.S. Treasury official, meanwhile, had contacted Barclays of Britain to suggest it consider taking a stake in Lehman. Fuld's top executives spent Friday shuttling between the two suitors' law firms.
Lehman was also exploring a third option: The night before, veteran bankruptcy lawyer Harvey Miller of Weil, Gotshal & Manges had secretly begun cobbling together a bare-bones bankruptcy filing for the firm.
Lehman's troubles were putting the rest of Wall Street on notice.
In a Merrill Lynch conference room in downtown Manhattan that morning, Thain was on a call with Merrill's board of directors, discussing how to address the chaos. "Lehman is going down, and the [short sellers] are coming after us next," warned Merrill director John Finnegan. "Tell me how this story is going to end differently."
Merrill would be fine, Thain said. "We are not Lehman," he responded, noting the firm held valuable assets, including its stake in BlackRock, a profitable asset-management firm.
But Merrill's clients, too, were beginning to pull out money. The firm's stock was sinking. Executives, including Merrill President Gregory Fleming, were nervous.
Fleming believed he'd identified the ideal partner for Merrill. Bank of America, with a strong balance sheet and retail operations, would mesh well with Merrill's securities franchise and 16,000-strong brokerage force. Fleming worried that Bank of America could buy Lehman instead.
Fleming called a long-time lawyer for Bank of America, Edward Herlihy of Wachtell, Lipton, Rosen & Katz. "You have to talk to us," Fleming said. He was told that Merrill's Thain would have to approach Bank of America's Lewis. "I know," Fleming responded. "I'm gonna try."
At 5 p.m. Friday, after a day of massive client withdrawals at Lehman, Thain's phone rang. It was the Treasury. "Be at the Fed at 6 p.m.," Thain was told.
Soon after, Thain gathered along with Morgan's Mack and Goldman's Blankfein at the New York Federal Reserve in downtown Manhattan, in a room once used to cash coupons on Treasury bills. The three men were greeted by the masters of the world's biggest economy -- Federal Reserve Chairman Ben Bernanke, Treasury Secretary Henry Paulson, New York Fed Chief Timothy Geithner and Securities and Exchange Commission chief Christopher Cox. It was a signal moment for the Wall Street firms, which after years of being monitored by the SEC would all soon come under the regulatory watch of a newly powerful Fed.
The federal officials told the Wall Street chiefs to return in the morning. If the mess at Lehman could be fixed, it would be the job of the Wall Street bosses. There would be no public bailout.
An industry-led solution wouldn't be without precedent. In the market panic of 1907, financier J.P. Morgan persuaded fellow bankers to help fund a bailout for failing rivals. Competitors united again in 1998, putting up money to insulate the financial system from the failure of hedge fund Long Term Capital Management.
But now, Fuld's problems at Lehman were possibly beyond repair.
By that night, Bank of America's team had concluded that Lehman's real-estate portfolio was worse than expected -- and as a result, the firm's liabilities likely exceeded its assets. "We need government assistance, and we are not getting it," the bank's top deal maker, Greg Curl, told his group. Some of the negotiators prepared to fly back early the next morning to headquarters in Charlotte.
Lewis hadn't come to New York for the Lehman talks. He called Fuld from Charlotte, telling him that Bank of America couldn't do a deal without federal help. "We will keep a team in New York in case things change," Lewis told him.
Saturday, Sept. 13
Fuld arrived at Lehman's office at 7 a.m. on Saturday, wearing a blue suit and tie. The talks with Barclays were still moving. If the government could be moved, there could also be hope for a Bank of America deal.
Merrill, meanwhile, was beginning its own pursuit of Bank of America.
At his home in Rye, N.Y., Thain was getting dressed for a day at the New York Fed when his phone rang. It was Merrill's president, Fleming.
"John, you really need to call Ken Lewis," Fleming said.
"Get me his number," said Thain, who added it to his papers for the day.
Thain's black SUV pulled up in front of the New York Fed just before 8 a.m. Top executives from all four investment banks -- minus Lehman's Fuld -- were there.
Federal officials broke Thain, Mack and Blankfein and their top aides into groups. One studied the potential fallout from a Lehman failure. Another was charged with putting a value on Lehman's controversial real-estate investments. A third group, which included Thain and Morgan's Mack, was supposed to discuss an industry-led bailout for Lehman.
Lehman's president, Bart McDade, walked the group through the embattled firm's books. McDade did not respond to requests for comment for this article.
Mack questioned Wall Street's ability to repair markets. The firms could try to backstop Lehman, he argued, but there was no guarantee they wouldn't have to rescue another rival later. "If we're going to do this deal, where does it end?" he said.
As McDade discussed Lehman's position, Thain had an epiphany: "This could be me sitting here next Friday."
Thain pushed his chair back and left the group to caucus with top Merrill officers. "Lehman is not going to make it," he told them.
Thain stepped to a sidewalk behind the New York Fed and called the Bank of America chief at his home in Charlotte. "I can be there in a few hours," Lewis said.
Members of Bank of America's deal team, exhausted from scrutinizing Lehman's books, had just landed in Charlotte. Lewis ordered them back to New York.
Up in Lehman's midtown office, Fuld was also dialing Lewis's North Carolina home. His calls went unreturned. "I can't believe that son of a bitch won't return my calls," he told a top adviser.
Lehman's bankruptcy team, meanwhile, was rolling into action. Shortly before noon, Miller, the Weil Gotshal bankruptcy head, sent an email to several partners. Lehman's name didn't appear in the email. Its subject line read: "Urgent. Code name: Equinox. Have desperate need for help on an emergency situation."
Throughout the day, Miller's attorneys, working with Federal Reserve officials and their attorneys, began seeking information from Lehman. But with Lehman's top officials tied up at the Fed and in Barclays negotiations, the lawyers were hard-pressed to get the details they needed.
"We were a distraction to the Lehman people," said Lori Fife, a Weil partner. "It felt like it was just a fire drill."
Later that afternoon, Merrill's chief executive met Bank of America's CEO, Lewis, in the bank's corporate apartment in the Time Warner Center. In a one-on-one meeting overlooking Central Park, the two men agreed that it looked like Lehman would be forced into bankruptcy.
Thain made his opening offer. "How about buying a 9.9 percent stake" in Merrill, he proposed.
Lewis said the bank doesn't tend to buy minority stakes. He suggested Bank of America could buy the whole firm.
"I am not here to sell Merrill Lynch," Thain responded.
"Well, that is what I want," Lewis countered.
The two parted with an agreement to keep talking.
Lehman's talks with Barclays, meanwhile, were moving forward at the New York Fed, under the eye of government officials. "Shouldn't I be there?" Fuld said to Lehman President Mr. McDade and to attorney Rodgin Cohen of Sullivan & Cromwell LLP, a longtime adviser.
What Fuld appeared not to know was that some top government officials had instructed key Lehman representatives at the Fed building to keep Fuld away that weekend. The federal officials had explained that Fuld -- not only Wall Street's longest-serving boss, but a director of the New York Fed -- could be an unnecessary distraction and a lightning rod for criticism.
At the Fed meetings, much of the talk was on the sidelines. When Thain returned to the New York Fed from his discussions with Lewis, Merrill advisers told him they had been approached by top Goldman executives. The rival house was interested in taking a 9.9 percent stake in Merrill and offered to extend a $10 billion line of credit.
Thain was digesting the news when he was approached by Mack of Morgan Stanley. "We should talk," Mack said. The bosses of Merrill and Morgan agreed to meet that evening. Soon, Thain and two advisers were en route to the Upper East Side apartment of a Morgan co-president.
Thain drank a Diet Coke as the Morgan and Merrill executives talked. Both sides felt there were benefits to merging. Thain indicated he needed a deal quickly. The meeting ended without a firm plan. "We have a board meeting Tuesday and can get back to you soon," Mack said before the group broke up.
As Thain and his advisers left the apartment, the Merrill chief suggested he had faint hopes for a deal with Morgan Stanley. "I don't think they share our sense of urgency," he said.
Merrill's talks with Bank of America, however, were on track at the bank's law firm, Wachtell Lipton. Merrill's team was camped out on Wachtell's 34th floor. Bank of America's team was on the 33rd. Around midnight, Lewis left the law firm for his apartment in the Time Warner Center. Pizza arrived at Wachtell at 3 a.m.
At Lehman's offices that evening, Fuld still hadn't heard back from Lewis. Attorneys from Weil were poring through documents, drawing up what would be the largest bankruptcy in U.S. history.
But in a rare piece of good news for Lehman, Barclays had agreed to buy Lehman, as long as it didn't have to take on its soured real-estate assets. Lehman's asset-management division would also be spun off. The Fed indicated that a syndicate of banks and brokers had agreed in principle to put up enough capital to support a separate company that would hold Lehman's bad real-estate assets.
Sunday, Sept. 14
A few hours later, at 8 a.m., Thain arrived at the Time Warner Center for a second one-on-one meeting in Lewis's corporate apartment. Over coffee, Thain made his case for a strong price for Merrill despite its stock's recent fall.
At the same time, Merrill officials were huddled with Goldman bankers. Some members of Merrill's team doubted that Goldman could save their firm by taking a 9.9 percent stake. Pete Kelly, a top Merrill lawyer, also had his reservations about letting rival Goldman see his firm's books. Still, the sides set a late-morning meeting at Merrill's offices.
At 9 a.m., the chiefs of finance arrived again at the New York Fed for a second day of meetings. By the time Thain arrived, the Merrill chief had a number of options in his back pocket.
Rolling up to the meetings at around the same time was Goldman's chief, Blankfein. A Goldman aide, referring to days of meltdowns and meetings, carped to Blankfein: "I don't think I can take another day of this."
Blankfein retorted: "You're getting out of a Mercedes to go to the New York Federal Reserve -- you're not getting out of a Higgins boat on Omaha Beach," he said, referring to the World War II experience of a former Goldman head. "So keep things in perspective."
At Lehman that morning, Fuld told his board of directors to gather at the firm's offices. By noon, he expected, the board would be able to approve Lehman's sale to Barclays.
One hurdle remained: To ink a Lehman deal, Barclays needed a shareholder vote. There was no way to get one on a Sunday. Barclays would need the U.S. or British government to back Lehman's trading balances until a vote could be held.
Government approval never came, though there are diverging views on why. Some blame the U.S. government for refusing to commit resources. Others say the British government refused to entertain a deal they worried would expose England to unnecessary risk.
Lehman's president, McDade, and Cohen, the attorney, called Fuld from the New York Fed. Passing McDade's cellphone back and forth, they broke the Barclays news.
Fuld postponed his board meeting. He made one more call to Charlotte, answered by Lewis's wife.
By midafternoon, word emerged that Bank of America was in talks with Merrill Lynch. Cohen, the attorney, broke the news to Fuld. "I guess this confirms our worst fears," Fuld said.
At the Fed, the Lehman executives and their bankruptcy attorneys faced roughly 25 officials from the Fed, Treasury and SEC. The Lehman officials pleaded for federal aid to keep Lehman afloat. But with Barclays and Bank of America off the table, Federal officials wanted a plan in place to soothe markets before trading opened in Asia.
A senior Fed official asked Miller, the Weil veteran who'd been involved in bankruptcy filings of companies including Bethlehem Steel and Marvel Entertainment, if Lehman was ready to file.
"No," Miller answered.
"You need more of a plan to prepare to do this," Miller continued. Lehman had tens of billions of dollars in derivative positions with countless parties. Unless these trades were unwound in an orderly way, it could shock all corners of the financial market. "This will cause financial Armageddon," he said.
Now, Merrill's Thain needed his own deal more than ever. With a Morgan tie-up looking like a long shot, Merrill focused its attentions on Goldman and Bank of America.
Tempers at Merrill flared as two rival teams pored over the firm's records. Merrill's head of strategy Peter Kraus, a Goldman alumnus hired by Thain, wanted to pull some of the firm's due-diligence staff away from the Bank of America project to look at Goldman's offer. "We need some people down here," Kraus said.
"We have a great deal in hand, and need to finish doing this deal," retorted Fleming, Merrill's president. A few minutes later, Thain called Fleming, telling him to send some people to work on the Goldman offer.
Fleming and Bank of America's lead negotiator, Curl, hammered out a price. Bank of America would buy Merrill for $29 a share.
Fleming informed Thain. At 6 p.m., Merrill's top managers and directors gathered in person and by phone.
"When I took this job this was not the outcome I intended," Thain told directors. After the board meeting broke up after 8 p.m., Thain called the chief of Bank of America. "The decision was unanimous," Thain told Mr. Lewis. "You have a deal."
A more somber scene was playing out at Lehman. Directors, who had been camped at the Midtown offices all day, gathered at around 8 p.m. in the firm's board room. Weil lawyers and Lehman executives summarized the Fed meeting to the frustrated board.
"They bailed out Bear," said Roland Hernandez, the former CEO of Spanish-language TV network Telemundo and a longtime Lehman board member. "Why not us?"
One of Fuld's assistants broke in to hand him a note: The SEC chairman wanted to address Lehman's board by speakerphone.
Cox, criticized for his allegedly minor role in the government's bailout of Bear Stearns, had been reluctant to call Lehman. The SEC chief finally called from the New York Fed, surrounded by several staffers, at the urging of Mr. Paulson, the Treasury secretary.
"This is serious," said Cox. "The board has a grave matter before it," he said.
John D. McComber, a former president of the Export-Import Bank and a Lehman director for 14 years, asked: "Are you directing us to authorize" a bankruptcy filing?
The SEC chief muted his phone. A minute later, he came back on the line. "You have a grave responsibility and you need to act accordingly," he replied.
As the meeting wrapped up around 10 p.m., Fuld, his suit jacket now off, leaned back in his chair. "I guess this is goodbye," he said. Lehman would file about four hours later.
Just a few blocks away, Merrill and Bank of America executives met to toast their deal. "I look forward to a great partnership with Merrill Lynch," Lewis said around midnight, a glass of champagne in hand.
The End
Rather than soothing markets, Lehman's bankruptcy filing roiled them -- slamming trading partners that had direct exposure to the firm and sowing fears that Wall Street's remaining giants weren't safe from failure. Shares of Morgan and Goldman plunged. In the credit-default swap market, the price of insurance against defaults of Morgan and Goldman soared.
Hedge funds sought to withdraw more than $100 billion in assets from Morgan Stanley. The firm's clearing bank, Bank of New York Mellon, wanted an extra $4 billion in collateral.
Morgan's chief, Mr. Mack, negotiated a cash infusion from Japan's Mitsubishi UFJ Financial Group. Fed and Treasury officials, concerned that a deal could be derailed by a declining Morgan share price, asked if Mack had other options. One regulator suggested Morgan Stanley consider selling itself to J.P. Morgan -- from which it had been famously split, 73 years earlier, amid post-Depression banking reform laws.
"We're going to get Mitsubishi done. There is no Plan B," Mack told one regulator.
Morgan did the deal. But investor fears remained. By Thursday, Fed officials were urging Morgan to become a commercial bank. Such a move would require Morgan to scale back its bets with borrowed money, run the risk of selling lucrative business lines and accept new onsite regulation from the Fed.
Mack consented, and the following weekend, Morgan Stanley formally ceased to be a securities firm.
The same weekend, Blankfein convened top lieutenants on his 30th-floor office. After 139 years as a securities firm, he said, Goldman, too, would also reshape itself as a commercial bank. Within hours, the era of Wall Street's giants was over.
Friday, October 17, 2008
Fed Rethinks Stance on Popping Bubbles
Source: WSJ
The Federal Reserve and academics who give it advice are rethinking the proposition that the Fed cannot and should not try to prick financial bubbles.
"[O]bviously, the last decade has shown that bursting bubbles can be an extraordinarily dangerous and costly phenomenon for the economy, and there is no doubt that as we emerge from the financial crisis, we will all be looking at that issue and what can be done about it," Fed Chairman Ben Bernanke said this week.
The bursting of this decade's housing bubble, which was accompanied by a bubble of cheap credit, has wrought inestimable economic damage. The U.S. economy was faltering before the crisis in credit markets recently intensified, rattling financial markets and sending home prices down further. Even if the government's decision to take stakes in major banks works, it could take weeks for money to flow freely again.
"A recession at least of the magnitude of 1982 is quite likely," said ITG economist Robert Barbera. The recession that ended in 1982 lasted 16 months -- twice as long as the 1991 and 2001 recessions -- and saw the unemployment rate rise to 10.8% from 7.2%.
While it is too soon to pronounce an about-face in Fed thinking, policy makers' views clearly are evolving. The Federal Reserve's longtime line on financial bubbles has been that they were impossible to identify. Even if the central bank could identify a bubble, policy makers said, trying to lance it would be far worse for the economy than letting the bubble run its course and dealing with the consequences.
Economists' view that central banks shouldn't meddle with financial bubbles was informed by the Fed's disastrous efforts to pop the stock-market bubble in the late 1920s, which led to the 1929 stock-market crash and contributed to the Great Depression. That view was reinforced when the Bank of Japan's pricking of the late 1980s' stock-market bubble shepherded in a decade of economic stagnation.
"[T]he degree of monetary tightening that would be required to contain or offset a bubble of any substantial dimension appears to be so great as to risk an unacceptable amount of collateral damage to the wider economy," former Fed Chairman Alan Greenspan said in 2002.
The Fed's view on bubbles helped fuel what became known as "the Greenspan put" -- the conviction among investors that the Fed would let them take excessive risks and step in as custodian if the bets they made went awry. By giving market participants an incentive to assume greater risk than they would have otherwise, the Fed's laissez-faire position on bubbles may have contributed to the surge in credit that helped push housing prices skyward in the first half of this decade.
Part of the problem was that the Fed applied the lessons of the dot-com bubble to housing and credit, says Harvard University economist Jeremy Stein. When Internet stock prices collapsed in 2000, the economic fallout was contained, because the use of leverage -- borrowing money to magnify bets -- was limited. The housing market is far more dependent on credit, and therefore leverage. As the issuance of mortgages expanded, and investors plunged money into complex securities based on those loans, matters got dangerously out of hand.
Identifying bubbles is tricky, with some seemingly irrational price spikes turning out to be justified. Policy makers need to be careful of valuing their judgment over the collective judgment of the market, because efforts to quash prices could interfere with the crucial role markets play in relaying information and allocating capital.
In recent years, economists have made headway in identifying incipient bubbles. Princeton University's Jose Scheinkman and Wei Xiong have shown how bubbles lead to overtrading -- whether day trading dot-com stocks or flipping condos -- and this might be a useful alert. Researchers at the Bank for International Settlements have flagged excessive credit growth signaling a bubble.
Once authorities identify a bubble, the next step is figuring out how to deal with it. Fed officials appear uncomfortable with the idea of raising interest rates to prick a bubble, because rates affect a wide swath of economic activity, and a bubble may be confined to just one area.
"Monetary policy, for which we in the Federal Reserve are responsible, is a blunt instrument with economy-wide effects," said Federal Reserve Bank of Minneapolis President Gary Stern. "We should not pretend that actions taken to rein in those asset-price increases, which seemingly outstrip economic fundamentals, won't in the short run curtail to some extent economic growth and employment."
Fed officials are leaning toward regulating financial firms with more of a focus on how they are contributing to risk throughout the financial system. This approach could also have drawbacks, said Princeton economist Hyun Song Shin.
"These Wall Street people are very intelligent, and their incentives are so vast that they're going to find a way to go around the rules you set down," he said. "Leaning against the wind by raising interest rates in the face of what seems like a credit boom is one way of at least damping down on potential excesses."
Tuesday, August 19, 2008
How Low Interest Rates Contributed to the Credit Crisis
WSJ: ETHAN PENNER
"What inning are we in?" How many times have we all heard that inane question asked and answered in the credit-driven downturn that we've been suffering through for over a year now?
We've heard many answers from financial industry and government leaders, such as "the worst is behind us," or "we'll not need to raise any further capital" -- only to learn in short order that our leaders really did not have the ability to make the market bend to their will.
To understand exactly what is happening, one needs to properly understand what occurred in the late stages of the prior cycle. Interest rates had been driven to historical lows in the U.S. and throughout the world. The cause of this can be debated. However, it is clear that economic globalization, with the migration of jobs to low-wage nations, had a profound impact on inflation, and thus on interest rates.In general, low interest rates are beneficial, as the low cost of capital encourages business borrowing for research and development, capital investment or expansion initiatives, which lead to job growth. Low interest rates also reduce the cost of homeownership, and, in fact, the cost of servicing any debt at all, thereby freeing up capital for more productive uses.
The flip side of a low-interest rate environment is that it reduces the absolute level of returns that are available to investors. This has significant implications for the massive wave of baby boomers, which holds many billions of dollars in retirement savings, either through direct investment or through managed pension-fund systems.
It is estimated by those in the pension-fund world that in order to meet the retirement needs of those baby boomers, their investments will need to yield a minimum of 8% per annum. When their money was set aside with this yield target in mind, rates on U.S. Treasuries hovered at high levels. However, in our most recent low-rate period, with U.S. Treasuries yielding 4% and below, achieving 8% became quite a challenge. The threat of not achieving it became both real and quite frightening for those whose retirement livelihood depends upon their pensions.
With a large portion of pension-fund asset allocations directed toward fixed-income investments that were yielding closer to 4%, the pressure to achieve an overall 8% on their portfolios drove investment managers to allocate large pools of capital to the strategies that promised higher returns. Even beyond the pension investment world, the global investor base had become comfortable in the last cycle with the notion that achieving an annual 20% or greater yield was possible. Thus huge amounts of investment capital migrated to funds promising lofty returns, and fund managers were pressured to advertise a 20% targeted yield or risk not attracting any capital.
It can be argued that it was the low interest-rate environment that actually fueled the huge boom in the hedge-fund and private-equity world that we've witnessed in the past decade. A major flaw in all this was that targeted returns became disconnected from the risk-free U.S. Treasury yield benchmark, to which all investments are implicitly pegged.
There is a direct relationship between returns and risk. If a five-year U.S. Treasury bond is yielding 8%, as it once did, a five-year corporate AAA-rated bond must provide a yield higher than 8% for it to be attractive to an investor, given its increased credit risk. And, further out on the risk spectrum, a five-year investment in a closed-end private equity fund must provide a much higher yield still -- perhaps as high as 20%.
If, however, the yield on the five-year Treasury bond falls to 3%, then the competitive market is set up such that yields on the more risky assets move down in relation, and a AAA-rated, five-year corporate bond will surely no longer be available at a yield above 8%. By extension, the yields available/achievable by the private equity fund, without taking heightened risk, must also fall to a number far below 20%.
Yet, in a low-rate environment, investors still insisted on this high yield target, and, in competing for capital, investment managers strived to achieve it -- mostly through the use of increased leverage or the acquisition of assets with greater risk profiles.
The system became burdened with the need to produce high returns, with many investors chasing that magic 20%, in spite of the fact that the yield targets had little to do with the realities of the low-rate environment.
The preferred formula for manufacturing high returns in a low-rate environment is actually quite simple: utilize large amounts of leverage. If, for example, you can buy an asset that produces a cash-flow yield of 6.5%, and leverage that 9:1 at a cost of borrowing of 5%, you've achieved your 20% target. This use of excessive leverage to capitalize upon low rates, and the easy availability of credit, began in the period after 9/11. Policy makers moved assertively to counteract the potentially devastating effect that tragedy might have had on our economy.
As investors scoured the market for assets with yields of 6.5%, the competition drove prices higher and yields lower. Investors started to buy assets with yields of 5%-5.5%, just barely above the cost of debt. They would justify the price by either borrowing still more or by creating a pro forma budget that reflected a plan for increasing revenues in time to levels that would achieve and surpass that 6.5% level, and that would ultimately produce the magic 20%.
The risk became that those ambitious growth goals would not be met -- and the buyer of the asset would be stuck with an overpriced and overleveraged investment, and a suboptimal yield.
As the market became more frenzied and prices continued to escalate in this competition to find yield, opportunistic buyers stepped in to buy an asset, almost without regard for its ability to create a suitable yield. They figured that someone flush with capital and in need of assets would buy it from them shortly at a quick-flip profit. These asset flippers, or traders, employed very little equity, and were granted large amounts of leverage for their activity, which had proved to be quite brilliant for a time.
Ultimately, as is always the case, there comes a time when someone rears his or her head and questions the sanity of a deal, and by implication, the entire market. At that moment, when everyone is fully invested and market participants have become most complacent about risk-management concerns, everything turns and the party ends abruptly. And thus begins the reversing of the leverage-driven run-up in asset values, with valuations ultimately returning to a level that is sensible and not predicated upon either excessive leverage or pro forma assumptions that everything will work out just perfectly.
Today, the pendulum has clearly swung very hard. Credit availability and cost have moved from one extreme to the other. In time, credit spreads will moderate, as lenders, whoever they will be in the next cycle, motivated by the need to earn revenue, will begin competing for good credits once again. Sadly, the benefits of this reduction in spread will more than likely be offset by an increase in the levels of real rates as the signs of inflation continue to appear.
In the meantime, we are still in the midst of what some analysts have dubbed "The Big Unwind," during which our system unwinds the excessive leverage of the past half-decade. We will likely see asset levels continue to adjust lower in order to come into alignment with today's more conservative lending environment and produce yields that would attract investment capital. There is no silver bullet that government or the financial community can shoot to bring this to a quick end.
Friday, January 18, 2008
We're all Keynesians now
Source: WSJ
So famously declared Richard Nixon back in 1971, in what we thought was a different economic era. But after yesterday, we're not sure what decade we're in. With Federal Reserve Chairman Ben Bernanke and President Bush both endorsing temporary tax cuts and more federal spending as "fiscal stimulus," an inflation-adjusted version of Jimmy Carter's $50 rebate can't be far behind.![[The Politics of Prices]](https://lh3.googleusercontent.com/blogger_img_proxy/AEn0k_tRuSn9iK-0ioBY_xhgBCoXI8PQLtyry6OVKTGrJrT1ZsKIRFVrH1aopHivw2MkOY_XNnACCZ3qmaXssPLTrJKDl2NcczfxRSLF83nGLSuW5XGoR3Gx3thampfmwzFqRU5tm0PfnO1c7IpKc0OF3A=s0-d)
So famously declared Richard Nixon back in 1971, in what we thought was a different economic era. But after yesterday, we're not sure what decade we're in. With Federal Reserve Chairman Ben Bernanke and President Bush both endorsing temporary tax cuts and more federal spending as "fiscal stimulus," an inflation-adjusted version of Jimmy Carter's $50 rebate can't be far behind.
Appearing before Congress, Mr. Bernanke told Democrats what he thought they wanted to hear. The former academic economist blessed a "fiscal stimulus package," as long as it is "explicitly temporary." How new federal spending can be "temporary," he didn't say, as if a dollar collected in taxes or borrowed and then spent can be recalled.
The "temporary" line was thus a dagger aimed directly at the heart of Mr. Bush's desire to make his tax cuts permanent. The Fed chief did aver that, "Again, I'm not taking a view one way or the other on the desirability of those long-term tax cuts being made permanent." But of course refusing to endorse something is itself a point of view -- a point Democrats were already joyfully repeating yesterday.
Instead, Mr. Bernanke embraced the explicit Keynesian notion that the government should write checks to "low and moderate income people," who will spend it quickly and thus lift consumer demand. In the academic literature, this is called having a higher "marginal propensity to consume" than the more affluent, who tend to save more.
We're all for putting more money in the hands of the poor and moderate earners, especially via stronger economic growth that will give them better paying jobs. But the $250 or $500 one-time rebate check they may now receive has to come from somewhere. The feds will pay for it either by taxing or borrowing from someone else, and those people will have that much less to spend or invest themselves. We are thus supposed to believe it is "stimulating" to take money from one pocket and hand it to another.
To put it another way, when the government calculates gross domestic product, it expressly omits transfer payments. It does so because GDP is the total of goods and services produced in the economy, and transfer payments produce no goods and services. The poor will spend those payments on something, but the amount they thus "inject" into the economy will be offset by whatever the government has to tax or borrow to fund the transfers. No wonder stocks sold off yesterday after Mr. Bernanke endorsed this 1970s' economic show.
A fiscal stimulus that really stimulates would change incentives, and do so permanently so workers and investors can know what to expect and take risks accordingly. One problem with the increasingly "temporary" nature of the Bush tax cuts is that they are beginning to introduce new political risk into economic decisions. Though they expire in 2010, everyone understands that a new President and Congress could act to raise taxes as soon as next year. Mr. Bernanke could have educated the public about this business expectations problem, but then Democrats would have been upset.
And Mr. Bernanke has his own political problems -- namely Congressional and Wall Street demands that he rescue mortgage assets by easing money even further, despite an already weak dollar and Wednesday's December inflation report that prices rose 4.1% in 2007. Yes, "core" inflation rose only 2.4%, but don't tell that to Americans who are paying the higher food and energy prices that the Fed excludes from "core" readings. As the nearby table with recent polling results shows, three of the four main economic issues cited by Americans are price-related. The public thinks we have an inflation problem even if the Fed doesn't.
Mr. Bernanke can expect to get pressure no matter what he does, and perhaps he figured the way to get more monetary running room was to give Congress what it wants on spending. If so, it doesn't inspire much trust in us that he can hold fast on monetary policy either. And speaking of the 1970s, what markets may really fear is that we are entering another period of "stagflation," slower growth with rising prices, and without political or economic leaders who understand what to do about it.
One truth that Mr. Bernanke did speak yesterday is that it is a mistake to rely on monetary policy alone to spur economic growth. It's a shame, then, that his testimony makes it that much less likely that we'll get any genuine "stimulus" from fiscal policy.
Wednesday, December 12, 2007
The Roots of the Mortgage Crisis
WSJ: Alan Greenspan
On Aug. 9, 2007, and the days immediately following, financial markets in much of the world seized up. ... Over the past five years, risk had become increasingly underpriced as market euphoria, fostered by an unprecedented global growth rate, gained cumulative traction.
The crisis was thus an accident waiting to happen. If it had not been triggered by the mispricing of securitized subprime mortgages, it would have been produced by eruptions in some other market. As I have noted elsewhere, history has not dealt kindly with protracted periods of low risk premiums.
The root of the current crisis, as I see it, lies back in the aftermath of the Cold War, when the economic ruin of the Soviet Bloc was exposed with the fall of the Berlin Wall. Following these world-shaking events, market capitalism quietly, but rapidly, displaced much of the discredited central planning that was so prevalent in the Third World.
A large segment of the erstwhile Third World, especially China, replicated the successful economic export-oriented model of the so-called Asian Tigers ... to unleash explosive economic growth. ...
The surge in competitive, low-priced exports from developing countries ... flattened labor compensation in developed countries, and reduced the rate of inflation expectations..., including those inflation expectations embedded in global long-term interest rates.
In addition, there has been a pronounced fall in global real interest rates since the early 1990s, which, of necessity, indicated that global saving intentions chronically had exceeded intentions to invest. ... Asset prices accordingly moved dramatically higher. Not only did global share prices recover from the dot-com crash, they moved ever upward. ...
After more than a half-century observing numerous price bubbles evolve and deflate, I have reluctantly concluded that bubbles cannot be safely defused by monetary policy or other policy initiatives before the speculative fever breaks on its own. There was clearly little the world's central banks could do to temper this most recent surge in human euphoria...
I do not doubt that a low U.S. federal-funds rate in response to the dot-com crash, and especially the 1% rate set in mid-2003 to counter potential deflation, ... may have contributed to the rise in U.S. home prices. In my judgment, however, the impact on demand for homes financed with ARMs was not major.
Demand in those days was driven by the expectation of rising prices -- the dynamic that fuels most asset-price bubbles. If low adjustable-rate financing had not been available, most of the demand would have been financed with fixed rate, long-term mortgages. ...
I and my colleagues at the Fed believed that the potential threat of corrosive deflation in 2003 was real, even though deflation was not thought to be the most likely projection. We will never know whether the temporary 1% federal-funds rate fended off a deflationary crisis, potentially much more daunting than the current one. But I did fret that maintaining rates too low for too long was problematic. The failure of either the growth of the monetary base, or of M2, to exceed 5% while the fed-funds rate was 1% assuaged my concern that we had added inflationary tinder to the economy.
In mid-2004, as the economy firmed, the Federal Reserve started to reverse the easy monetary policy. I had expected ... a consequent increase in long-term interest rates, which might have helped to dampen the then mounting U.S. housing price surge. It did not happen. We had presumed long-term rates, including mortgage rates, would rise, as had been the case at the beginnings of five previous monetary policy tightening episodes, dating back to 1980. But after an initial surge in the spring of 2004, long-term rates fell back and, despite progressive Federal Reserve tightening through 2005, long-term rates barely moved.
In retrospect, global economic forces, which have been building for decades, appear to have gained effective control of the pricing of longer debt maturities. Simple correlations between short- and long-term interest rates in the U.S. remain significant, but have been declining for over a half-century... More generally, global forces, combined with lower international trade barriers, have diminished the scope of national governments to affect the paths of their economies.
Although central banks appear to have lost control of longer term interest rates, they continue to be dominant in the markets for assets with shorter maturities, where money and near monies are created. Thus central banks retain their ability to contain pressures on the prices of goods and services, that is, on the conventional measures of inflation.
The current credit crisis will come to an end when the overhang of inventories of newly built homes is largely liquidated, and home price deflation comes to an end. ... Very large losses will, no doubt, be taken as a consequence of the crisis. But after a period of protracted adjustment, the U.S. economy, and the world economy more generally, will be able to get back to business.
Wednesday, November 07, 2007
ECB, After Hard Birth, Comes of Age in Crisis
ECB, After Hard Birth,
Comes of Age in Crisis
Europe Bank Gets Points
For First-Response Role;
War Games in Frankfurt
For First-Response Role;
War Games in Frankfurt
By JOELLEN PERRY, WSJ, Nov 6, 2007.
FRANKFURT -- At 12:32 p.m. on Thursday, Aug. 9, just past its ninth birthday, the European Central Bank grew up.
The summer's mounting financial crisis, sparked by rising defaults on U.S. subprime mortgages, had fully crossed the Atlantic that morning. European banks feared their counterparts were exposed to risky investments linked to these mortgages, and became unusually reluctant to lend to each other. Financial institutions were paralyzed.
![[Jean-Claude Trichet]](https://lh3.googleusercontent.com/blogger_img_proxy/AEn0k_tH2IddQhduPtMGwb9fvByS5Et1eAWMKSWCh9sjv_IWT_nQNXozgAPjCo4wjiIUL5vZj8J7UfdkDYQ__oK7-bztG_6iDpifITRl2eQD-Z6hYZoYfRppxnU40qwKvCzZMhp_1fF-1xsD_8U36OGEvfhrULUd=s0-d)
Tasked with stopping such a meltdown was the European Central Bank, which sets monetary policy for 13 countries from Ireland to Greece. The institution has been dogged since inception by criticisms that it valued consensus over decisiveness. Early on, it had been called slow-footed, disorganized and prone to miscommunicating its intentions.
But that day, the ECB swooped to the rescue. The bank offered unlimited overnight loans at its policy rate of 4%. By day's end, it had lent €94.8 billion -- about $131 billion -- which was more than it had put into money markets the day after Sept. 11, 2001. The first response by a major central bank to the summer's crisis, it stunned markets for its size. It also surprised counterparts at the U.S. Federal Reserve, who followed the ECB's injection with a smaller $24 billion one of their own later that day.
Observers credit the ECB and its head, Jean-Claude Trichet, with making a trenchant decision that calmed markets. The move shored up confidence in the bank's ability to keep markets functioning for the U.S. dollar's most significant rival. With its boosted credibility, the ECB could enhance the euro's standing in world markets. Continued confidence in the currency could ultimately come at the expense of the dollar, the current favorite of big world investors thanks in part to the size, liquidity and stability of U.S. markets.
"There were always worries that the ECB would be a stereotypical European institution, slow to decide and going off in multiple directions at once," says Adam Posen of the Peterson Institute for International Economics, a Washington think tank. "Mr. Trichet has put that to rest in this situation."
The ECB now faces fresh challenges. Global stock markets are swooning as the credit-market fallout deepens, with big write-downs and CEO departures at Citigroup Inc. and Merrill Lynch & Co. spurring fears that other banks could post more big losses. European bank shares fell yesterday, helping to bring down major indexes. And, as in the U.S. and United Kingdom, the gap between the rates euro-zone institutions charge each other for longer-term loans and the ECB's target rate remains unusually wide, suggesting markets remain tense.
A FORMER BANKER COMMENTS
"When 9/11 happened, there was some skepticism that we weren't prepared, because we were too new. We knew we could do it, but we had no track record. I think the ECB has done a perfect job."
-- Read more from former ECB board member Otmar Issing's interview with The Wall Street Journal.
-- Read more from former ECB board member Otmar Issing's interview with The Wall Street Journal.
This complicates the picture for ECB policy makers, who meet Thursday. Prior to the summer's credit-market unrest, robust euro-zone growth had the bank set for at least one more interest-rate rise this year. Now policy makers are caught between worries that inflation pressures are building, while the economy has yet to feel the full effect of credit-market turmoil, bank-sector write-offs and the euro's surge. In contrast to the Fed, which has cut rates by 3/4 of a percentage point since September, the ECB is likely to keep its key rate on hold Thursday. Investors see a protracted pause, but some policy makers have said the rate still could rise.
A portrait of the ECB's August response to the financial crisis emerges from documents, public statements and people familiar with the bank's workings. The ECB had been primed for a liquidity lockup, running Pentagon-style war games with such scenarios as early as April 2005. Its president, long-time French central banker Mr. Trichet, had warned loudly that investors were underestimating the danger of risky holdings. After market tremors earlier in the summer, ECB staffers who monitor markets were on high alert.
Some observers criticized the ECB for inciting panic with its intervention, saying the scope of its response suggested the bank was bracing for a catastrophe. A few still say the ECB overreacted, arguing that the offer of unlimited funds at the ECB's target rate -- the central-bank equivalent of a fire sale -- rewarded the type of risky investments that spurred the subprime debacle to start with.
The ECB still has vulnerabilities, of course, as separate events over the past three months have demonstrated. A communication gaffe by the bank left financial markets confused for days in mid-August about whether the ECB intended to raise rates. A fragmented system of bank supervision left it without detailed information about bank balance sheets at a moment of crisis. And it faces persistent sniping from politicians as it refuses to restrain a rise in the euro on foreign-exchange markets that is provoking yelps from some exporters.
Derided From Start
The ECB was established on June 1, 1998. Critics derided the institution as unworkable from the start. To shore up credibility, the ECB modeled itself after Germany's inflation-phobic Bundesbank. Like the U.S. Federal Reserve, the ECB sets a target for interest rates on overnight loans between banks. But unlike the Fed, whose dual mandate makes it attentive to both inflation and growth, the ECB's prime focus is on keeping prices stable. It aims to keep inflation at just under 2% in the 13 countries that now share the euro currency.
The ECB's rate-setting body includes the six members of its Executive Board, who oversee the bank's day-to-day operations, plus the 13 heads of the euro-zone's national central banks. Rather than voting on interest-rate decisions and publishing the minutes of their meetings, as Fed officials do, the ECB's 19 Governing Council members make decisions by consensus. The bank explains its thinking in a news conference after each decision.
The euro debuted with fanfare, and an initial value of $1.17, in 1999. Although the ECB's primary focus is inflation, not the exchange rate, a falling currency can be read as a market vote of no-confidence in an economy and its managers. Over the next 22 months, amid scattershot communication from ECB policy makers, the euro deteriorated to 83 cents.
The bank's now-deceased first president, Wim Duisenberg, initially reinforced the perception of disorganization. Although he had been an accomplished former Dutch central-bank head, the lanky policy maker with a mop of white hair became known at the ECB for a colloquial candor, uncommon in central-banking circles, that repeatedly steered markets the wrong way. British tabloids dubbed him "Dim Wim."
War Games
Since late 2003, the ECB's public face has been Mr. Trichet. A poetry buff who studied economics and mining engineering, the 64-year-old Mr. Trichet is long on practical experience, from the French Treasury to the World Bank. He was president of the Paris Club of creditor nations from 1985 to 1993, an era in which Latin American, African and Russian debts were restructured, and head of the French central bank for a decade.
By 2005, the ECB was preparing for potential market chaos. That April, at its 37-story glass-and-metal headquarters in Frankfurt, 65 participants spent two and half days in exercises aimed at honing their response to a future crisis. About a year later, some 150 people took part in a conference from their home countries to play out shocks to the financial system. In 40 teleconference calls over half a week, the group responded to various scenarios, including a prescient case in which banks sought emergency loans but policy makers didn't know whether the banks were solvent. Top policy makers were barraged by rumors, sometimes contradictory, and by actors playing inquisitive journalists.
The real thing arrived this summer. For months, U.S. homeowners with subprime mortgages -- high-interest loans extended to high-risk borrowers -- had been defaulting in rising numbers. Investors who had bought opaque securities backed by these mortgages ran into trouble as the securities became difficult to value and thus potentially hard to trade.
By late July, there were mounting clues that continental European banks were vulnerable. On July 27, the little-known German IKB Deutsche Industriebank AG revealed it had major exposure to the U.S. subprime-mortgage market, prompting an emergency weekend €3.5 billion bailout organized by Germany's financial regulator, with contributions from major German banks.
Markets lurched into early August. Even as European business slowed for vacation, the ECB's team of market monitors -- usually about 15 people, whittled to around a dozen because of vacations -- was on alert. Working on the second floor of the bank's high-rise, the team watches everything from global stock-exchange movements to copper prices.
Some five members of the team monitor money-market rates, the interest banks charge each other for loans. In the afternoon of Tuesday, Aug. 7, rates on loans ranging from overnight to a year started rising. This was puzzling: Just that morning, the ECB had conducted its regular weekly refinancing operations. That should have provided banks with enough cash to last them the week -- and, by extension, kept the rates between banks relatively flat.
In phone calls with the market monitors, commercial bank treasurers confirmed their banks were antsy.
Wednesday brought more jitters. Though the ECB had set its target rate at 4%, overnight money-market rates continued rising above that. Investors were fleeing to havens such as two-year German government bonds. Data showed commercial banks' reserves with the central bank had fallen, another sign that banks might be hoarding cash.
U.S. VS. EURO ZONE
Projected 2007 GDP*:
U.S.: $13.794 trillion
Euro zone: $11.905 trillion
U.S.: $13.794 trillion
Euro zone: $11.905 trillion
Unemployment:
U.S.: 4.7% (October)
Euro zone: 7.3% (September)
U.S.: 4.7% (October)
Euro zone: 7.3% (September)
Consumer prices, growth from year earlier:
U.S.: 2.8% (September)
Euro zone: 2.6% (October)
U.S.: 2.8% (September)
Euro zone: 2.6% (October)
Current account deficit as % of GDP, second quarter:
U.S.: 5.5%
Euro zone: 0.1%
U.S.: 5.5%
Euro zone: 0.1%
Population, 2006
U.S.: 299.4 million
Euro zone: 316.7 million**
U.S.: 299.4 million
Euro zone: 316.7 million**
*Converted to U.S. dollars at current rate.
**Includes population of Slovenia, admitted to the euro zone Jan. 1, 2007.
**Includes population of Slovenia, admitted to the euro zone Jan. 1, 2007.
Sources: IMF World Economic Outlook database, Eurostat, Bureau of Labor Statistics, Commerce Department, U.S. Census
By Wednesday evening, staffers had suggested that the six-member Executive Board consider taking the unusual step of injecting cash to restore calm. By then, Mr. Trichet and Lucas Papademos, the ECB's vice president, were in touch with U.S. Fed governors.
The ECB prefers to stage major interventions before noon, when commercial-bank treasurers are sure to be at their desks. The bank decided to wait until the morning and act if markets were still tense.
They were. At 8:30 a.m. on Thursday, Aug. 9, major French bank BNP Paribas announced it was suspending withdrawals from three investment funds because it couldn't value them amid the subprime crisis. Rumors flew that other banks were in trouble.
"I've never experienced anything like it," says Christoph Rieger, interest-rate strategist at Dresdner Kleinwort in Frankfurt. The fear "ground the market to a halt."
Extraordinary Tension
Interest rates on overnight loans between European banks soared. Typically, market monitors snap to attention if the overnight rate moves a few hundredths of a point away from the bank's policy rate. Now, rates hit 4.7%, far above the ECB's 4% target, signaling extraordinary tension.
Convening at 8:45 a.m., the ECB liquidity group decided to recommend intervening that morning and taking the unprecedented step of pre-announcing that the bank would honor every bid it received. To send a clear signal that the bank was covering the market's back, the committee settled on offering funds at the bank's 4% policy rate rather than a variable rate or a higher penalty rate. Taken together, the moves would show the ECB just how high the demand for cash was, because banks, in principle, would bid for exactly what they felt they needed. The ECB could use the information to judge future injections more accurately.
The six Executive Board members approved the move within 90 minutes.
At 10:26 a.m., the bank told markets it stood "ready to act." At 12:32 p.m., it flashed its decision on trading screens across the euro zone. The notice said the ECB would accept bids for funds until 1:05 p.m. Response was immediate. At 2 p.m., the ECB publicized the total take of €94.8 billion. The overnight rate fell back down to around 4%. In subsequent days and weeks, the ECB continued to add funds to money markets to keep the market liquid.
But challenges continued to arise, in part because the ECB doesn't have detailed insight into the euro zone's banks. While the Fed effectively supervises most of the biggest U.S. banks and has access to detailed information on these banks' books, the ECB cedes banking supervision to each member country.
Days after its Aug. 9 fund injection, the central bank sent commercial-bank supervisors across the euro zone a questionnaire asking about their subprime exposure. The basic question: Were banks basically sound and just having a problem with short-term liquidity? Or were some of them in deeper trouble?
Some responses were returned quickly and fully. Others came back late or without sufficient numbers. In the end, the ECB learned enough to be confident that banks were sound. But some people in and out of the ECB are unsure that the bank would get the information it needs in a bigger crisis.
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In the following weeks, another old ECB problem resurfaced -- communicating intentions clearly to the market. Mr. Trichet had been getting high marks for predictability, but that changed on Aug. 22.
On the back of the ECB's continuing cash injections, overnight lending rates had fallen back to around the 4% target. But three-month interbank rates still hovered around 4.7%, a sign that banks were reluctant to lend to each other for longer periods.
At 3:34 p.m. that day, the ECB released a surprise statement saying it would hold an auction the following day, accepting bids for €40 billion in extra three-month funds. Markets greeted the announcement with relief. But the statement's last sentence caused confusion. "The position of the Governing Council of the ECB on its monetary policy stance was expressed by its president on 2 August 2007," it read.
That was a reference to a briefing held by Mr. Trichet weeks earlier, at which he indicated that the bank, at the time, was inclined to raise short-term rates at its next meeting on Sept. 6. In the intervening turmoil, however, markets had steadily revised down expectations of an ECB interest-rate rise. The late August statement seemed to put a hike back in play.
"To say markets didn't know how to interpret it is putting it mildly," says Dresdner Kleinwort's Mr. Rieger.
Crossed Signals
The communication problem was compounded two days later, on Aug. 24. Anonymous sources at several national central banks leaked word to Reuters that markets had misinterpreted the sentence about the ECB's monetary-policy intentions: ECB policy makers were not set on raising rates. Speaking in Budapest a few days later, Mr. Trichet intervened to clarify the message, essentially telling markets that policy makers hadn't decided whether to move rates.
On Sept. 6, the bank kept its policy rate unchanged at 4%.
Observers say that while the bank proved its chops with its early August moves, it still has room to master the subtle art of communicating its intent. "It's as important as moving rates well," says Luigi Buttiglione, a former Bank of Italy economist, now with New York-based investment fund Fortress Investment Group in London, who praised the August intervention. "You not only have to do the right thing, but you have to explain why this is the right thing. If you're not able to do that, then markets can take a different direction -- and you can achieve the opposite result."
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