Don't Blame Greenspan
By David Henderson
It's become conventional wisdom that Alan Greenspan's Federal Reserve was responsible for the housing crisis. Virtually every commentator who blames Mr. Greenspan points to the low interest rates during his last few years at the Fed.
The link seems obvious. Everyone knows that the Fed can drive interest rates lower by pumping more money into the economy, right? Well, yes. But it doesn't follow that that's why interest rates were so low in the early 2000s. Other factors affect interest rates too. In particular, a sudden increase in savings will drive down interest rates. And such a shift did occur. As Mr. Greenspan pointed out on this page on March 11, there was a surge in savings from other countries. Although he names only China, some of the Middle Eastern oil-producing countries were also responsible for much of this new saving. Shift the supply curve to the right and, wonder of wonders, the price falls. In this case, the price of saving and lending is the interest rate.
But how do we know that it was an increase in saving, not an increase in the money supply, that caused interest rates to fall? Look at the money supply.
Since 2001, the annual year-to-year growth rate of MZM (money of zero maturity, which is M2 minus small time deposits plus institutional money market shares) fell from over 20% to nearly 0% by 2006. During that time, M2 (which is M1 plus time deposits) growth fell from over 10% to around 2%, and M1 (which is currency plus demand deposits) growth fell from over 10% to negative rates.
The annual growth rate of the monetary base, the magnitude over which the Fed has the most control, fell from 10% in 2001 to below 5% in 2006. Moreover, nearly all of the growth in the monetary base went into currency, an increasing proportion of which is held abroad.
Moreover, if the Fed was the culprit, why was the housing bubble world-wide? Do Mr. Greenspan's critics seriously contend that the Fed was responsible for high housing prices in, say, Spain?
This is not to say that the Greenspan Fed was blameless. Particularly disturbing is the way the lender-of-last-resort function has increased moral hazard, a trend to which Mr. Greenspan contributed and which current Fed Chairman Ben Bernanke has put on steroids.
But to the extent that the federal government is to blame, the main fed culprits are the beefed up Community Reinvestment Act and the run-amok Fannie Mae and Freddie Mac. All played a key role in loosening lending standards.
I'm not claiming that we should have a Federal Reserve. We simply can't depend on getting another good chairman like Mr. Greenspan, and are more likely to get another Arthur Burns or Ben Bernanke. Serious work by economists Lawrence H. White of the University of Missouri, St. Louis, and George Selgin of West Virginia University makes a persuasive case that abolishing the Fed and deregulating money would improve the macroeconomy. I'm making a more modest claim: Mr. Greenspan was not to blame for the housing bubble.
Mr. Henderson is a research fellow with the Hoover Institution, an economics professor at the Naval Postgraduate School, and editor of "The Concise Encyclopedia of Economics" (Liberty Fund, 2008).
What Savings Glut?
By Gerald P. O'Driscoll Jr.
Alan Greenspan responded to his critics on these pages on March 11. He singled out an op-ed by John Taylor a month earlier, "How Government Created the Financial Crisis" (Feb. 9), for special criticism. Mr. Greenspan's argument defending his policy is two-fold: (1) the Fed controls overnight interest rates, but not "long-term interest rates and the home-mortgage rates driven by them"; and (2) a global excess of savings was "the presumptive cause of the world-wide decline in long-term rates."
Neither argument stands up to scrutiny. First, Mr. Greenspan writes as if mortgages were of the 30-year variety, financed by 30-year money. Would that it were so! We would not be in the present mess. But the post-2002 period was characterized by one-year adjustable-rate mortgages (ARMs), teaser rates that reset in two or three years, etc. Five-year ARMs became "long-term" money.
The Fed only determines the overnight, federal-funds rate, but movements in that rate substantially influence the rates on such mortgages. Additionally, maturity-mismatches abounded and were the source of much of the current financial stress. Short-dated commercial paper funded investment banks and other entities dealing in mortgage-backed securities.
Second, Mr. Greenspan offers conjecture, not evidence, for his claim of a global savings excess. Mr. Taylor has cited evidence from the IMF to the contrary, however. Global savings and investment as a share of world GDP have been declining since the 1970s. The data is in Mr. Taylor's new book, "Getting Off Track."
The former Fed chairman also cautions against excessive regulation as a policy response to the crisis. On this point I concur. He does not directly address, however, the Fed's policy response. From the beginning, the Fed diagnosed the problem as lack of liquidity and employed every means at its disposal to supply liquidity to credit markets. It has been to little avail and, in the process, the Fed has loaded up its balance sheet with dubious assets.
The credit crunch continues because many banks are capital-impaired, not illiquid. Treasury's policy shifts and inconsistencies under both administrations have sidelined potential private capital. Treasury became the capital provider of last resort. It was late to recognize the hole in banks' balance sheets and consistently underestimated its size. The need to provide second- and even third-round capital injections proves that.
In summary, Fed policy did help cause the bubble. Subsequent policy responses by that institution have suffered from sins of commission and omission. As Mr. Taylor argued, the government (including the Fed) caused, prolonged, and worsened the crisis. It continues doing so.
Mr. O'Driscoll is a senior fellow at the Cato Institute. He was formerly a vice president at the Federal Reserve Bank of Dallas.
Low Rates Led to ARMs
By Todd J. Zywicki
Alan Greenspan's argument that the Federal Reserve's policies on short-term interest rates had no impact on long-term mortgage interest rates overlooks the way in which its policies changed consumer behavior.
A simple yet powerful pattern emerges from survey data of the past 25 years collected by HSH Associates (the financial publishers): The spread between fixed-rate mortgages (FRMs) and ARMs typically hovers between 100 and 150 basis points, representing the premium that a borrower has to pay to induce the lender to bear the risk of interest-rate fluctuations. At times, however, the spread between FRMs and ARMs breaks out of this band and becomes either larger or smaller than average, leading marginal consumers to prefer one to the other. Sometimes the adjustment in the market share of ARMs lags behind changes in the size of the spread, but over time when the spread widens, the percentage of ARMs increases and vice-versa.
In 1987, before subprime lending was even a gleam in Angelo Mozilo's eye, the spread rose to 300 basis points and the share of ARMs eventually rose to almost 70%, according to the Federal Finance Housing Board. When the spread shrunk to near 100 basis points in the late-1990s, the percentage of ARMs fell into the single digits. Other periods of time show similar dynamics.
In the latest cycle the spread rose from under 50 basis points at the end of 2000 to 230 basis points in mid-2004 and the percentage of ARMs rose from 10% to 40%. The Fed's subsequent increases on short-term rates caused short- and long-term rates to converge, squeezing the spread to about 50 points by 2007 and reducing ARMs to less than 10% of the market.
Record-low ARM interest rates kept housing generally affordable even as buyers could stretch to pay higher prices. Low short-term interest rates, combined with tax and other policies, also drew speculative, short-term home-flippers into certain markets. As the Fed increased short-term rates in 2005-07, interest rate resets raised monthly payments, triggering the initial round of defaults and falling home prices. Foreclosure rates initially soared on both prime and subprime ARMS much more than for FRMs.
Why did the ARM substitution result in a wave of foreclosures this time, unlike prior times? During previous times with high percentages of ARMs, the dip in short-term interest rates was a leading indicator of an eventual decline in long-term rates, reflecting the general downward trend in rates of the past 25 years. By contrast, during this housing bubble the interest rate on ARMs were artificially low and eventually rose back to the level of FRMs. There were other factors that exacerbated the problem -- most notably increased risk-layering and a decline in underwriting standards -- but the Fed's artificial lowering of short-term interest rates and the resulting substitution by consumers to ARMs triggered the bubble and subsequent crisis.
Mr. Zywicki is a professor of law at George Mason University School of Law and a senior scholar at the university's Mercatus Center. He is writing a book on consumer bankruptcy and consumer credit.
The Fed Provided the Fuel
By David Malpass
The blame for the current crisis extends well beyond the Fed -- to banks, regulators, bond raters, mortgage fraud, the Bush administration's weak-dollar policy and Lehman bankruptcy decisions, and Congress's reckless housing policies through Fannie Mae and Freddie Mac and the Community Reinvestment Act.
But the Fed provided the key fuel with its 1% interest rate choice in 2003 and 2004 and "measured" (meaning inadequate) rate hikes in 2004-2006. It ignored inflationary dollar weakness, higher interest rate choices abroad, the Taylor Rule, and the booming performance of the U.S. and global economies.
Even by the Fed's own backward-looking inflation metrics, the core consumption deflator exceeded the Fed's 2% limit for 18 quarters in a row beginning with the second quarter of 2004, while 12-month Consumer Price Index (CPI) inflation hit 4.7% in September 2005 and 5.4% in July 2008. This despite the Fed's constant assurances that inflation would moderate (unlikely given the crashing dollar.)
Despite its role as regulator and rate-setter, the Fed claimed that it could not identify asset bubbles until they popped (see my rebuttal on this page "The Fed's Moment of Weakness," Sept. 25, 2002). It is clear that the Fed's interest rate polices cause wide swings in the value of the dollar and huge momentum-based capital flows. These bring predictable -- and avoidable -- deflations, inflations and asset bubbles.
Beginning in 2003, the Fed filled the liquidity punch bowl. Low rates and the weakening dollar created a monumental carry trade (borrow dollars, buy anything). This transmitted the Fed's monetary excess abroad and into commodities. As the punch bowl overflowed, even global bonds bubbled (prices rose, yields fell), contributing to the global housing boom. Alan Greenspan singled out this correlation in his March 11 op-ed on this page, "The Fed Didn't Cause the Housing Bubble."
Given this power, the Fed should itself stop the current deflation and the economic freefall. It has to add enough liquidity to offset frozen credit markets, the collapse in the velocity of money, and bank deleveraging (which has reversed the normal money multiplier.)
The Fed was on the right track in late November when it committed to purchasing $600 billion in longer-term, government-guaranteed securities. Equities rose globally, and some credit markets thawed, including a decline in mortgage rates and corporate bond spreads. However, the Fed reversed course in January, delaying its asset purchases and shrinking its balance sheet. Growth in the money supply stopped. Since then, the Fed increased the amount of assets it intends to purchase, but lengthened the time period rather than accelerating the pace of purchases.
Given the magnitude of the crisis and the stakes, the Fed should be buying safe assets fast, not parceling out a few billion. Confidence and money velocity would also increase if the Fed committed itself to dollar stability, not instability, to avoid causing future inflations and deflations.
Mr. Malpass is president of Encima Global LLC.
Loose Money and the Derivative Bubble
By Judy Shelton
The Fed owns this crisis. The buck stops there -- but it didn't.
Too many dollars were churned out, year after year, for the economy to absorb; more credit was created than could be fruitfully utilized. Some of it went into subprime mortgages, yes, but the monetary excess that fueled the most threatening "systemic risk" bubble went into highly speculative financial derivatives that rode atop packaged, mortgage-backed securities until they dropped from exhaustion.
The whole point of having a central bank is to calibrate the money supply to the genuine needs of an economy -- to purchase goods and services, to fund productive investment -- with the aim of achieving maximum sustainable long-term growth. Since price stability is a key factor toward that end, central bankers attempt to finesse the amount of money and credit in the system; if interest rates are kept too low too long, it causes an unwarranted expansion of credit. As the money supply increases relative to real economic production, the spillage of excess purchasing power results in higher prices for goods and services.
But not always. Sometimes the monetary excess finds its way into a narrow sector of the economy -- such as real estate, or equities, or rare art. This time it was the financial derivatives market.
In the last six years, according to the Bank for International Settlements, the derivatives market exploded as a global haven for speculative investment, its aggregate notional value rising more than fivefold to $684 trillion in 2008 from $127 trillion in 2002. Financial obligations amounting to 12 times the value of the entire world's gross domestic product were written and traded and retraded among financial institutions -- playing off every instance of market turbulence, every gyration in exchange rates, every nuanced statement uttered by a central banker in Washington or Frankfurt -- like so many tulip contracts.
The sheer enormity of this speculative bubble, let alone the speed at which it inflated, testifies to inordinately loose monetary policy from the Fed, keeper of the world's predominant currency. The fact that Fannie Mae and Freddie Mac provided the "underlying security" for many of the derivative contracts merely compounds the error of government intervention in the private sector. Politicians altered normal credit risk parameters, while the Fed distorted housing prices through perpetual inflation.
At this point, dickering over whether Alan Greenspan should have formulated monetary policy in strict accordance with an econometrically determined "rule," or whether the Fed even has the power to influence long-term rates, raises a more fundamental question: Why do we need a central bank?
"There are numbers of us, myself included, who strongly believe that we did very well in the 1870 to 1914 period with an international gold standard." That was Mr. Greenspan, speaking 17 months ago on the Fox Business Network.
In the rules-versus-discretion debate over how best to achieve sound money, that is the ultimate answer.
Ms. Shelton, an economist, is author of "Money Meltdown" (Free Press, 1994).
To Change Policy, Change The Law
By Vincent Reinhart
Anyone seeking an application of the principle that fame is fleeting need look no further than the assessment of Federal Reserve policy from 2002 to 2005.
At the beginning, capital spending was anemic, and considerable wealth had been destroyed by the equity crash. The recovery from the 1990-91 recession was "jobless," and the current one was following the same script. Moreover, inflation was so distinctly pointed down that deflation seemed a palpable threat.
Keeping the federal-funds rate low for a long time was viewed as appropriately balancing the risks to the Fed's dual objectives of maximum employment and price stability. Indeed, the Fed was seen as extending the stable economic performance since 1983 that had been dubbed the "Great Moderation."
Over the period 2002-2005, the federal-funds rate ran below the recommendation of the policy rule made famous by Stanford Professor John Taylor. No doubt, the Taylor Rule provides important guidance on how that rate should change in response to changes in the two mandated goals of policy. First, it should move up or down by more than any change in inflation. Second, the Fed should respond to changes in resource slack. That is, caring about unemployment is not a sign of weakness in a central banker but rather that of strength in better achieving good results.
The Taylor Rule is less helpful to practitioners of policy in anchoring the level of the federal-funds rate. The rule is fit to experience based on a notion of the rate that should prevail if inflation were at its goal and resources fully employed, which is known as the equilibrium funds rate. That is an important technicality. Using a faulty estimate of the equilibrium funds rate is like flying a plane that is otherwise perfect except for an unreliable altimeter. The exception looms large when flying over a mountainous region.
From 2002 to 2005, the economic landscape appeared especially changeable, with the contours shaped by lower wealth, lingering job losses, and looming disinflation. To Fed officials at the time, this indicated that the equilibrium funds rate was unusually low. Simply, the only way to provide lift to an economy in which resource use was slack and inflation pointed down was to keep policy accommodative relative to longer-term standards.
That was then. Now, policy during the period is seen as fueling a housing bubble.
The Fed is guilty as charged in setting policy to achieve the goals mandated in the law. Fed policy makers cannot be held responsible for the fuel to speculative fires provided by foreign saving and the thin compensation for risk that satisfied global investors. Nor can the chain of subsequent mistakes that drove a downturn into a debacle be laid at the feet of the Federal Open Market Committee of 2002 to 2005. If the results seem less than desirable in retrospect, change the law those policy makers were following, but do not blame them for following prevailing law.
Mr. Reinhart is a resident scholar at the American Enterprise Institute. From August 2001 to June 2007, he was the secretary and economist of the Federal Open Market Committee.
Monday, March 30, 2009
Thursday, March 19, 2009
The Fed Did Not Cause the Housing Bubble
Alan Greenspan
We are in the midst of a global crisis that will unquestionably rank as the most virulent since the 1930s. It will eventually subside and pass into history. But how the interacting and reinforcing causes and effects of this severe contraction are interpreted will shape the reconfiguration of our currently disabled global financial system.
There are at least two broad and competing explanations of the origins of this crisis. The first is that the "easy money" policies of the Federal Reserve produced the U.S. housing bubble that is at the core of today's financial mess.
The second, and far more credible, explanation agrees that it was indeed lower interest rates that spawned the speculative euphoria. However, the interest rate that mattered was not the federal-funds rate, but the rate on long-term, fixed-rate mortgages. Between 2002 and 2005, home mortgage rates led U.S. home price change by 11 months. This correlation between home prices and mortgage rates was highly significant, and a far better indicator of rising home prices than the fed-funds rate.
This should not come as a surprise. After all, the prices of long-lived assets have always been determined by discounting the flow of income (or imputed services) by interest rates of the same maturities as the life of the asset. No one, to my knowledge, employs overnight interest rates -- such as the fed-funds rate -- to determine the capitalization rate of real estate, whether it be an office building or a single-family residence.
The Federal Reserve became acutely aware of the disconnect between monetary policy and mortgage rates when the latter failed to respond as expected to the Fed tightening in mid-2004. Moreover, the data show that home mortgage rates had become gradually decoupled from monetary policy even earlier -- in the wake of the emergence, beginning around the turn of this century, of a well arbitraged global market for long-term debt instruments.
U.S. mortgage rates' linkage to short-term U.S. rates had been close for decades. Between 1971 and 2002, the fed-funds rate and the mortgage rate moved in lockstep. The correlation between them was a tight 0.85. Between 2002 and 2005, however, the correlation diminished to insignificance.
As I noted on this page in December 2007, the presumptive cause of the world-wide decline in long-term rates was the tectonic shift in the early 1990s by much of the developing world from heavy emphasis on central planning to increasingly dynamic, export-led market competition. The result was a surge in growth in China and a large number of other emerging market economies that led to an excess of global intended savings relative to intended capital investment. That ex ante excess of savings propelled global long-term interest rates progressively lower between early 2000 and 2005.
That decline in long-term interest rates across a wide spectrum of countries statistically explains, and is the most likely major cause of, real-estate capitalization rates that declined and converged across the globe, resulting in the global housing price bubble. (The U.S. price bubble was at, or below, the median according to the International Monetary Fund.) By 2006, long-term interest rates and the home mortgage rates driven by them, for all developed and the main developing economies, had declined to single digits -- I believe for the first time ever. I would have thought that the weight of such evidence would lead to wide support for this as a global explanation of the current crisis.
However, starting in mid-2007, history began to be rewritten, in large part by my good friend and former colleague, Stanford University Professor John Taylor, with whom I have rarely disagreed. Yet writing in these pages last month, Mr. Taylor unequivocally claimed that had the Federal Reserve from 2003-2005 kept short-term interest rates at the levels implied by his "Taylor Rule," "it would have prevented this housing boom and bust. "This notion has been cited and repeated so often that it has taken on the aura of conventional wisdom.
Aside from the inappropriate use of short-term rates to explain the value of long-term assets, his statistical indictment of Federal Reserve policy in the period 2003-2005 fails to address the aforementioned extraordinary structural developments in the global economy. His statistical analysis carries empirical relationships of earlier decades into the most recent period where they no longer apply.
Moreover, while I believe the "Taylor Rule" is a useful first approximation to the path of monetary policy, its parameters and predictions derive from model structures that have been consistently unable to anticipate the onset of recessions or financial crises. Counterfactuals from such flawed structures cannot form the sole basis for successful policy analysis or advice, with or without the benefit of hindsight.
Given the decoupling of monetary policy from long-term mortgage rates, accelerating the path of monetary tightening that the Fed pursued in 2004-2005 could not have "prevented" the housing bubble. All things considered, I personally prefer Milton Friedman's performance appraisal of the Federal Reserve. In evaluating the period of 1987 to 2005, he wrote on this page in early 2006: "There is no other period of comparable length in which the Federal Reserve System has performed so well. It is more than a difference of degree; it approaches a difference of kind."
How much does it matter whether the bubble was caused by inappropriate monetary policy, over which policy makers have control, or broader global forces over which their control is limited? A great deal.
If it is monetary policy that is at fault, then that can be corrected in the future, at least in principle. If, however, we are dealing with global forces beyond the control of domestic monetary policy makers, as I strongly suspect is the case, then we are facing a broader issue.
Global market competition and integration in goods, services and finance have brought unprecedented gains in material well being. But the growth path of highly competitive markets is cyclical. And on rare occasions it can break down, with consequences such as those we are currently experiencing. It is now very clear that the levels of complexity to which market practitioners at the height of their euphoria tried to push risk-management techniques and products were too much for even the most sophisticated market players to handle properly and prudently.
However, the appropriate policy response is not to bridle financial intermediation with heavy regulation. That would stifle important advances in finance that enhance standards of living. Remember, prior to the crisis, the U.S. economy exhibited an impressive degree of productivity advance. To achieve that with a modest level of combined domestic and borrowed foreign savings (our current account deficit) was a measure of our financial system's precrisis success. The solutions for the financial-market failures revealed by the crisis are higher capital requirements and a wider prosecution of fraud -- not increased micromanagement by government entities.
Any new regulations should improve the ability of financial institutions to effectively direct a nation's savings into the most productive capital investments. Much regulation fails that test, and is often costly and counterproductive. Adequate capital and collateral requirements can address the weaknesses that the crisis has unearthed. Such requirements will not be overly intrusive, and thus will not interfere unduly in private-sector business decisions.
If we are to retain a dynamic world economy capable of producing prosperity and future sustainable growth, we cannot rely on governments to intermediate saving and investment flows. Our challenge in the months ahead will be to install a regulatory regime that will ensure responsible risk management on the part of financial institutions, while encouraging them to continue taking the risks necessary and inherent in any successful market economy.
Mr. Greenspan, former chairman of the Federal Reserve, is president of Greenspan Associates LLC and author of "The Age of Turbulence: Adventures in a New World" (Penguin, 2007).
We are in the midst of a global crisis that will unquestionably rank as the most virulent since the 1930s. It will eventually subside and pass into history. But how the interacting and reinforcing causes and effects of this severe contraction are interpreted will shape the reconfiguration of our currently disabled global financial system.
There are at least two broad and competing explanations of the origins of this crisis. The first is that the "easy money" policies of the Federal Reserve produced the U.S. housing bubble that is at the core of today's financial mess.
The second, and far more credible, explanation agrees that it was indeed lower interest rates that spawned the speculative euphoria. However, the interest rate that mattered was not the federal-funds rate, but the rate on long-term, fixed-rate mortgages. Between 2002 and 2005, home mortgage rates led U.S. home price change by 11 months. This correlation between home prices and mortgage rates was highly significant, and a far better indicator of rising home prices than the fed-funds rate.
This should not come as a surprise. After all, the prices of long-lived assets have always been determined by discounting the flow of income (or imputed services) by interest rates of the same maturities as the life of the asset. No one, to my knowledge, employs overnight interest rates -- such as the fed-funds rate -- to determine the capitalization rate of real estate, whether it be an office building or a single-family residence.
The Federal Reserve became acutely aware of the disconnect between monetary policy and mortgage rates when the latter failed to respond as expected to the Fed tightening in mid-2004. Moreover, the data show that home mortgage rates had become gradually decoupled from monetary policy even earlier -- in the wake of the emergence, beginning around the turn of this century, of a well arbitraged global market for long-term debt instruments.
U.S. mortgage rates' linkage to short-term U.S. rates had been close for decades. Between 1971 and 2002, the fed-funds rate and the mortgage rate moved in lockstep. The correlation between them was a tight 0.85. Between 2002 and 2005, however, the correlation diminished to insignificance.
As I noted on this page in December 2007, the presumptive cause of the world-wide decline in long-term rates was the tectonic shift in the early 1990s by much of the developing world from heavy emphasis on central planning to increasingly dynamic, export-led market competition. The result was a surge in growth in China and a large number of other emerging market economies that led to an excess of global intended savings relative to intended capital investment. That ex ante excess of savings propelled global long-term interest rates progressively lower between early 2000 and 2005.
That decline in long-term interest rates across a wide spectrum of countries statistically explains, and is the most likely major cause of, real-estate capitalization rates that declined and converged across the globe, resulting in the global housing price bubble. (The U.S. price bubble was at, or below, the median according to the International Monetary Fund.) By 2006, long-term interest rates and the home mortgage rates driven by them, for all developed and the main developing economies, had declined to single digits -- I believe for the first time ever. I would have thought that the weight of such evidence would lead to wide support for this as a global explanation of the current crisis.
However, starting in mid-2007, history began to be rewritten, in large part by my good friend and former colleague, Stanford University Professor John Taylor, with whom I have rarely disagreed. Yet writing in these pages last month, Mr. Taylor unequivocally claimed that had the Federal Reserve from 2003-2005 kept short-term interest rates at the levels implied by his "Taylor Rule," "it would have prevented this housing boom and bust. "This notion has been cited and repeated so often that it has taken on the aura of conventional wisdom.
Aside from the inappropriate use of short-term rates to explain the value of long-term assets, his statistical indictment of Federal Reserve policy in the period 2003-2005 fails to address the aforementioned extraordinary structural developments in the global economy. His statistical analysis carries empirical relationships of earlier decades into the most recent period where they no longer apply.
Moreover, while I believe the "Taylor Rule" is a useful first approximation to the path of monetary policy, its parameters and predictions derive from model structures that have been consistently unable to anticipate the onset of recessions or financial crises. Counterfactuals from such flawed structures cannot form the sole basis for successful policy analysis or advice, with or without the benefit of hindsight.
Given the decoupling of monetary policy from long-term mortgage rates, accelerating the path of monetary tightening that the Fed pursued in 2004-2005 could not have "prevented" the housing bubble. All things considered, I personally prefer Milton Friedman's performance appraisal of the Federal Reserve. In evaluating the period of 1987 to 2005, he wrote on this page in early 2006: "There is no other period of comparable length in which the Federal Reserve System has performed so well. It is more than a difference of degree; it approaches a difference of kind."
How much does it matter whether the bubble was caused by inappropriate monetary policy, over which policy makers have control, or broader global forces over which their control is limited? A great deal.
If it is monetary policy that is at fault, then that can be corrected in the future, at least in principle. If, however, we are dealing with global forces beyond the control of domestic monetary policy makers, as I strongly suspect is the case, then we are facing a broader issue.
Global market competition and integration in goods, services and finance have brought unprecedented gains in material well being. But the growth path of highly competitive markets is cyclical. And on rare occasions it can break down, with consequences such as those we are currently experiencing. It is now very clear that the levels of complexity to which market practitioners at the height of their euphoria tried to push risk-management techniques and products were too much for even the most sophisticated market players to handle properly and prudently.
However, the appropriate policy response is not to bridle financial intermediation with heavy regulation. That would stifle important advances in finance that enhance standards of living. Remember, prior to the crisis, the U.S. economy exhibited an impressive degree of productivity advance. To achieve that with a modest level of combined domestic and borrowed foreign savings (our current account deficit) was a measure of our financial system's precrisis success. The solutions for the financial-market failures revealed by the crisis are higher capital requirements and a wider prosecution of fraud -- not increased micromanagement by government entities.
Any new regulations should improve the ability of financial institutions to effectively direct a nation's savings into the most productive capital investments. Much regulation fails that test, and is often costly and counterproductive. Adequate capital and collateral requirements can address the weaknesses that the crisis has unearthed. Such requirements will not be overly intrusive, and thus will not interfere unduly in private-sector business decisions.
If we are to retain a dynamic world economy capable of producing prosperity and future sustainable growth, we cannot rely on governments to intermediate saving and investment flows. Our challenge in the months ahead will be to install a regulatory regime that will ensure responsible risk management on the part of financial institutions, while encouraging them to continue taking the risks necessary and inherent in any successful market economy.
Mr. Greenspan, former chairman of the Federal Reserve, is president of Greenspan Associates LLC and author of "The Age of Turbulence: Adventures in a New World" (Penguin, 2007).
Sunday, March 01, 2009
Why Stimulus Will Mean Inflation
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.
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.
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.
Bank Bailout Plan Revamped
Source: WSJ
Treasury Secretary Timothy Geithner is expected to announce that the government will become a partner with the private sector to purchase banks' troubled assets, according to people familiar with the matter.
The plan for a so-called aggregator bank, a variation on a theme that Obama administration officials have wrestled with for weeks, is among four main components of Mr. Geithner's bailout revamp, which he is expected to announce Tuesday.
The effort to restore confidence to the financial system comprises a broad range of tools and government agencies. It includes fresh cash injections into banks; new programs to help possibly 2.5 million struggling homeowners; a significant expansion of a Federal Reserve program designed to jump-start consumer lending; and, lastly, the mechanism to allow banks to get rid of bad assets.
The administration's plans have evolved over the past several weeks as it has considered and discarded a host of ideas, with financial markets anxiously awaiting details. Mr. Geithner had planned an announcement Monday but delayed it a day to allow the focus to remain on the stimulus bill in Congress.
The aggregator bank, which some refer to as a "bad bank," would be designed to solve a fundamental challenge: How can banks purge themselves of their bad bets without worsening their weakened condition?
The entity would be seeded with funds from the $700 billion financial-sector bailout fund, but the idea is that most financing would come from the private sector. Some critical elements remained unclear, including exactly how the government would entice investors to participate in the private bank, given that they can already buy soured assets on the open market if they want to. The government will likely offer some type of incentive, such as limiting the risk associated with buying the assets.
The administration hasn't settled on exactly how it will work and intends to hash out the structure with the private sector over the next few weeks, the people familiar with the matter said. Investors would likely buy a stake in the entity, which would then buy mortgage-backed securities and other troubled assets.
The government would also be an investor, but the terms aren't yet decided. The entity might also raise funds by selling government-backed debt or through financing from the Fed, the people familiar with the matter said.
The Obama administration views the private bank as a way to get around the thorny issue of having to determine a price for soured assets such as certain mortgage-backed securities, many of which are illiquid and hard to value. The government has long worried that if it bought toxic assets and paid too much for them, banks would benefit at the expense of taxpayers -- while if the price was too low, it would force banks to take further write-downs and exacerbate their woes.
The Treasury's working theory for the government/private-sector partnership is that investors wouldn't overpay, because if they did, they'd stand to lose money; but they also wouldn't underpay, since the selling banks wouldn't be willing to part with their assets too cheaply.
Bankers and investors cautiously welcomed the idea, saying it could help avoid more large-scale federal intrusions into the financial sector while tackling the bad-asset problem. Brian Sterling, co-head of investment banking for advisory firm Sandler O'Neill & Partners, called the idea an "interesting tool" worth exploring.
"We think that anything that helps facilitate taking nonperforming assets off bank balance sheets or putting a ringfence around them is a good thing," Mr. Sterling said. Some investors expressed concern about joining with the government in such an arrangement if the rules of engagement weren't guaranteed to remain consistent.
Executives at J.P. Morgan Chase & Co. have been cool to the idea of selling assets into a "bad bank" structure. They believe it may be wiser to hold on to sour assets that have already been written down, in the hope the bank can recoup losses when markets revive.
Many of the administration's ideas appear to build on policies begun under former Treasury Secretary Henry Paulson, whose handling of the bailout helped tar its reputation among lawmakers and the public. Mr. Paulson's plan initially envisioned buying toxic assets but shifted to having the government inject cash into banks in return for preferred stock. Many of the housing ideas under consideration also stem from work done in the Bush administration, illustrating the constrained range of options.
Mr. Geithner is expected to sell the program as a break with the past, pitching it as a comprehensive framework to address the root causes of the financial crisis: defaulting loans and soured assets that are shaking confidence in banks.
Other likely elements of the plan, subject to last-minute changes, include:
An expansion of the Fed's Term Asset-Backed Securities Loan Facility to include assets beyond the student-loan, auto-loan and credit-card debt it was set up to absorb. Under the revamp, the so-called TALF is likely to buy securities backed by commercial real estate and possibly other assets as well. The program was set up during the Bush administration to spur the consumer-loan market by providing financing for investors to buy securities backed by such loans.
A second round of cash injections in financial firms but with tougher terms, such as a requirement to modify troubled mortgages and better track the federal funds. The government is looking to get money into banks by buying preferred shares that convert into common shares in seven years; the idea is to avoid diluting current shareholders' stakes while helping banks better withstand losses. The Treasury may also allow banks that have already received capital to convert the Treasury's preferred shares to common stock over time.
Dow Jones Newswires columnist Simon Constable finds out from MarketBeat blogger David Gaffen what U.S. Treasury Secretary Timothy Geithner is expected to unveil in his new plans to fix the financial crisis.
Giving the Federal Deposit Insurance Corp. power to help dismantle troubled financial firms beyond the depository institutions over which it now has authority. This could require legislation.
Mr. Geithner, his predecessor Mr. Paulson and Fed Chairman Ben Bernanke have said there needs to be a government entity empowered to wind down failed financial institutions that aren't banks. Regulators have said one problem the government faced when Lehman Brothers Holdings Inc. and American International Group Inc. ran into trouble was that no federal body had authority to step in and steer the firms toward an orderly demise.
Having the FDIC guarantee a wider range of debt that banks issue to fund loans is also a likely element of the plan, said people familiar with the matter. The guarantees could help free up credit to both companies and consumers. Currently, the FDIC temporarily backs certain debt with a three-year maturity. Government officials could increase this to maturities up to 10 years.
More help for homeowners, at a cost of between $50 billion and $100 billion. The administration is expected to create national standards for loan modifications that would be adopted by mortgage giants Fannie Mae and Freddie Mac. The plan could include a mechanism to determine the value of homes facing foreclosure, which could speed negotiations with borrowers. The difficulty of valuing such homes is one reason many loan-modification efforts have stalled.
A related move would see the government using taxpayer dollars to give mortgage companies an incentive to modify loans. One idea would help reduce interest rates for consumers by having the government match mortgage companies' interest-rate reductions to some degree. For instance, if a mortgage company agreed to shave one point off the rate on a loan, the government might match that so the rate would be reduced by two points. Mr. Geithner is also expected to express support for legislation that would allow judges to modify the terms of mortgages in bankruptcy court.
A public-relations makeover. To improve the bailout's poor image, which owes partly to the shifting nature of the government's remedies, the administration is considering renaming the $700 billion Troubled Asset Relief Program and making it independent of the Treasury. The U.S. is going to announce new terms and conditions for companies that receive or have already taken government aid -- in addition to the new executive-compensation limits announced this week -- including a demand that they report how the money is being spent.
Treasury Secretary Timothy Geithner is expected to announce that the government will become a partner with the private sector to purchase banks' troubled assets, according to people familiar with the matter.
The plan for a so-called aggregator bank, a variation on a theme that Obama administration officials have wrestled with for weeks, is among four main components of Mr. Geithner's bailout revamp, which he is expected to announce Tuesday.
The effort to restore confidence to the financial system comprises a broad range of tools and government agencies. It includes fresh cash injections into banks; new programs to help possibly 2.5 million struggling homeowners; a significant expansion of a Federal Reserve program designed to jump-start consumer lending; and, lastly, the mechanism to allow banks to get rid of bad assets.
The administration's plans have evolved over the past several weeks as it has considered and discarded a host of ideas, with financial markets anxiously awaiting details. Mr. Geithner had planned an announcement Monday but delayed it a day to allow the focus to remain on the stimulus bill in Congress.
The aggregator bank, which some refer to as a "bad bank," would be designed to solve a fundamental challenge: How can banks purge themselves of their bad bets without worsening their weakened condition?
The entity would be seeded with funds from the $700 billion financial-sector bailout fund, but the idea is that most financing would come from the private sector. Some critical elements remained unclear, including exactly how the government would entice investors to participate in the private bank, given that they can already buy soured assets on the open market if they want to. The government will likely offer some type of incentive, such as limiting the risk associated with buying the assets.
The administration hasn't settled on exactly how it will work and intends to hash out the structure with the private sector over the next few weeks, the people familiar with the matter said. Investors would likely buy a stake in the entity, which would then buy mortgage-backed securities and other troubled assets.
The government would also be an investor, but the terms aren't yet decided. The entity might also raise funds by selling government-backed debt or through financing from the Fed, the people familiar with the matter said.
The Obama administration views the private bank as a way to get around the thorny issue of having to determine a price for soured assets such as certain mortgage-backed securities, many of which are illiquid and hard to value. The government has long worried that if it bought toxic assets and paid too much for them, banks would benefit at the expense of taxpayers -- while if the price was too low, it would force banks to take further write-downs and exacerbate their woes.
The Treasury's working theory for the government/private-sector partnership is that investors wouldn't overpay, because if they did, they'd stand to lose money; but they also wouldn't underpay, since the selling banks wouldn't be willing to part with their assets too cheaply.
Bankers and investors cautiously welcomed the idea, saying it could help avoid more large-scale federal intrusions into the financial sector while tackling the bad-asset problem. Brian Sterling, co-head of investment banking for advisory firm Sandler O'Neill & Partners, called the idea an "interesting tool" worth exploring.
"We think that anything that helps facilitate taking nonperforming assets off bank balance sheets or putting a ringfence around them is a good thing," Mr. Sterling said. Some investors expressed concern about joining with the government in such an arrangement if the rules of engagement weren't guaranteed to remain consistent.
Executives at J.P. Morgan Chase & Co. have been cool to the idea of selling assets into a "bad bank" structure. They believe it may be wiser to hold on to sour assets that have already been written down, in the hope the bank can recoup losses when markets revive.
Many of the administration's ideas appear to build on policies begun under former Treasury Secretary Henry Paulson, whose handling of the bailout helped tar its reputation among lawmakers and the public. Mr. Paulson's plan initially envisioned buying toxic assets but shifted to having the government inject cash into banks in return for preferred stock. Many of the housing ideas under consideration also stem from work done in the Bush administration, illustrating the constrained range of options.
Mr. Geithner is expected to sell the program as a break with the past, pitching it as a comprehensive framework to address the root causes of the financial crisis: defaulting loans and soured assets that are shaking confidence in banks.
Other likely elements of the plan, subject to last-minute changes, include:
An expansion of the Fed's Term Asset-Backed Securities Loan Facility to include assets beyond the student-loan, auto-loan and credit-card debt it was set up to absorb. Under the revamp, the so-called TALF is likely to buy securities backed by commercial real estate and possibly other assets as well. The program was set up during the Bush administration to spur the consumer-loan market by providing financing for investors to buy securities backed by such loans.
A second round of cash injections in financial firms but with tougher terms, such as a requirement to modify troubled mortgages and better track the federal funds. The government is looking to get money into banks by buying preferred shares that convert into common shares in seven years; the idea is to avoid diluting current shareholders' stakes while helping banks better withstand losses. The Treasury may also allow banks that have already received capital to convert the Treasury's preferred shares to common stock over time.
Dow Jones Newswires columnist Simon Constable finds out from MarketBeat blogger David Gaffen what U.S. Treasury Secretary Timothy Geithner is expected to unveil in his new plans to fix the financial crisis.
Giving the Federal Deposit Insurance Corp. power to help dismantle troubled financial firms beyond the depository institutions over which it now has authority. This could require legislation.
Mr. Geithner, his predecessor Mr. Paulson and Fed Chairman Ben Bernanke have said there needs to be a government entity empowered to wind down failed financial institutions that aren't banks. Regulators have said one problem the government faced when Lehman Brothers Holdings Inc. and American International Group Inc. ran into trouble was that no federal body had authority to step in and steer the firms toward an orderly demise.
Having the FDIC guarantee a wider range of debt that banks issue to fund loans is also a likely element of the plan, said people familiar with the matter. The guarantees could help free up credit to both companies and consumers. Currently, the FDIC temporarily backs certain debt with a three-year maturity. Government officials could increase this to maturities up to 10 years.
More help for homeowners, at a cost of between $50 billion and $100 billion. The administration is expected to create national standards for loan modifications that would be adopted by mortgage giants Fannie Mae and Freddie Mac. The plan could include a mechanism to determine the value of homes facing foreclosure, which could speed negotiations with borrowers. The difficulty of valuing such homes is one reason many loan-modification efforts have stalled.
A related move would see the government using taxpayer dollars to give mortgage companies an incentive to modify loans. One idea would help reduce interest rates for consumers by having the government match mortgage companies' interest-rate reductions to some degree. For instance, if a mortgage company agreed to shave one point off the rate on a loan, the government might match that so the rate would be reduced by two points. Mr. Geithner is also expected to express support for legislation that would allow judges to modify the terms of mortgages in bankruptcy court.
A public-relations makeover. To improve the bailout's poor image, which owes partly to the shifting nature of the government's remedies, the administration is considering renaming the $700 billion Troubled Asset Relief Program and making it independent of the Treasury. The U.S. is going to announce new terms and conditions for companies that receive or have already taken government aid -- in addition to the new executive-compensation limits announced this week -- including a demand that they report how the money is being spent.
Saturday, February 07, 2009
Greed is Good
Source: WSJ
1973 was a terrible year on Wall Street. An unexpected crisis in the Middle East led to a quadrupling of oil prices and a serious global economic recession. The president was in serious trouble with Watergate. The S&P 500 index dropped 50% (after 23 years of rising markets), and much of Wall Street fell deeply into the red. There were no profits, and therefore no bonuses.
I was a 35-year-old, nonpartner investment banker then and was horrified to learn that my annual take-home pay would be limited to my small salary, which accounted for about a quarter of my previous year's income. Fortunately the partners decided to pay a small bonus out of their capital that year to help employees like me get by. The next year was no better. Several colleagues with good prospects left the firm and the industry for good. We learned that strong pay-for-performance compensation incentives could cut both ways.
Many wondered if that was still the case last week, when New York State Comptroller Thomas DiNapoli released an estimate that the "securities industry" paid its New York City employees bonuses of $18 billion in 2008, leading to a public outcry. Lost in the denunciations were the powerful benefits of the bonus system, which helped make the U.S. the global leader in financial services for decades. Bonuses are an important and necessary part of the fast-moving, high-pressure industry, and its employees flourish with strong performance incentives.
There is also a fundamental misunderstanding of how bonuses are paid that is further inflaming public opinion. The system has become more complex than most people know, and involves forms of bonuses that are not entirely discretionary.
The anger at Wall Street only grew at the news that Merrill Lynch, after reporting $15 billion of losses, had rushed to pay $4 billion in bonuses on the eve of its merger with Bank of America. Because Merrill Lynch and Bank of America were receiving substantial government funds to keep them afloat, the subject became part of the public business. The idea that the banks had paid out taxpayers' funds in undeserved bonuses to employees, together with a leaked report of John Thain's spending $1 million to redecorate his office, understandably provoked a blast of public outrage against Wall Street. The issue was so hot that President Barack Obama interrupted his duties to call the bonuses "shameful" and the "height of irresponsibility." Then, on Wednesday, he announced a new set of rules for those seeking "exceptional" assistance from the Troubled Asset Relief Program in the future that would limit cash compensation to $500,000 and restrict severance pay and frills, perks and boondoggles.
Lindsay Holmes
In the excitement some of the facts got mixed up. Mr. DiNapoli's estimate included many firms that were not involved with the bailout, and only a few that were. Merrill's actions were approved by its board early in December and consented to by Bank of America. But the basic point is that, despite the dreadful year that Wall Street experienced in 2008, some questionable bonuses were paid to already well-off employees, and that set off the outrage.
Many Americans believe that any bonuses for top executives paid by rescued banks would constitute "excess compensation," a phrase used by Mr. Obama. But no Wall Street CEO taking federal money received a bonus in 2008, and the same was true for most of their senior colleagues. Not only did those responsible receive no bonuses, the value of the stock in their companies paid to them as part of prior-year bonuses dropped by 70% or more, leaving them, collectively, with billions of dollars of unrealized losses.
That's pay for performance, isn't it?
"Wall Street" has always been the quintessential, if ill-defined, symbol of American capitalism. In reality, Wall Street today includes many large banks, investment groups and other institutions, some not even located in the U.S. It has become a euphemism for the global capital markets industry -- one in which the combined market value of all stocks and bonds outstanding in the world topped $140 trillion at the end of 2007. Well less than half of the value of this combined market value is represented by American securities, but American banks lead the world in its origination and distribution. Wall Street is one of America's great export industries.
The market thrives on locating new opportunities, providing innovation and a willingness to take risks. It is also, regrettably, subject to what the economist John Maynard Keynes called "animal spirits," the psychological factors that make markets irrational when going up or down. For example, America has enjoyed a bonus it didn't deserve in its free-wheeling participation in the housing market, before it became a bubble. Despite great efforts by regulators to manage systemic risk, there have been market failures. The causes of the current market failure, which is the real object of the public anger, go well beyond the Wall Street compensation system -- but compensation has been one of them.
The capital-markets industry operates in a very sophisticated and competitive environment, one that responds best to strong performance incentives. People who flourish in this environment are those who want to be paid and advanced based on their individual and their team's performance, and are willing to take the risk that they might be displaced by someone better or that mistakes or downturns may cause them to be laid off or their firms to fail. Indeed, since 1970, 28 major banks or investment banks have failed or been taken up into mergers, and thousands have come and gone into the industry without making much money. Those that have survived the changing fortunes of the industry have done very well -- so well, in fact, that they appear to have become symbolic of greedy and reckless behavior.
The Wall Street compensation system has evolved from the 1970s, when most of the firms were private partnerships, owned by partners who paid out a designated share of the firm's profits to nonpartner employees while dividing up the rest for themselves. The nonpartners had to earn their keep every year, but the partners' percentage ownerships in the firms were also reset every year or two. On the whole, everyone's performance was continuously evaluated and rewarded or penalized. The system provided great incentives to create profits, but also, because the partners' own money was involved, to avoid great risk.
The industry became much more competitive when commercial banks were allowed into it. The competition tended to commoditize the basic fee businesses, and drove firms more deeply into trading. As improving technologies created great arrays of new instruments to be traded, the partnerships went public to gain access to larger funding sources, and to spread out the risks of the business. As they did so, each firm tried to maintain its partnership "culture" and compensation system as best it could, but it was difficult to do so.
In time there was significant erosion of the simple principles of the partnership days. Compensation for top managers followed the trend into excess set by other public companies. Competition for talent made recruitment and retention more difficult and thus tilted negotiating power further in favor of stars. Henry Paulson, when he was CEO of Goldman Sachs, once remarked that Wall Street was like other businesses, where 80% of the profits were provided by 20% of the people, but the 20% changed a lot from year to year and market to market. You had to pay everyone well because you never knew what next year would bring, and because there was always someone trying to poach your best trained people, whom you didn't want to lose even if they were not superstars. Consequently, bonuses in general became more automatic and less tied to superior performance. Compensation became the industry's largest expense, accounting for about 50% of net revenues. Warren Buffett, when he was an investor in Salomon Brothers in the late 1980s, once noted that he wasn't sure why anyone wanted to be an investor in a business where management took out half the revenues before shareholders got anything. But he recently invested $5 billion in Goldman Sachs, so he must have gotten over the problem.
As firms became part of large, conglomerate financial institutions, the sense of being a part of a special cohort of similarly acculturated colleagues was lost, and the performance of shares and options in giant multi-line holding companies rarely correlated with an individual's idea of his own performance over time. Nevertheless, the system as a whole worked reasonably well for years in providing rewards for success and penalties for failures, and still works even in difficult markets such as this one.
At junior levels, bonuses tend to be based on how well the individual is seen to be developing. As employees progress, their compensation is based less on individual performance and more on their role as a manager or team leader. For all professional employees the annual bonus represents a very large amount of the person's take-home pay. At the middle levels, bonuses are set after firm-wide, interdepartmental negotiation sessions that attempt to allocate the firm's compensation pool based on a combination of performance and potential.
1973 was a terrible year on Wall Street. An unexpected crisis in the Middle East led to a quadrupling of oil prices and a serious global economic recession. The president was in serious trouble with Watergate. The S&P 500 index dropped 50% (after 23 years of rising markets), and much of Wall Street fell deeply into the red. There were no profits, and therefore no bonuses.
I was a 35-year-old, nonpartner investment banker then and was horrified to learn that my annual take-home pay would be limited to my small salary, which accounted for about a quarter of my previous year's income. Fortunately the partners decided to pay a small bonus out of their capital that year to help employees like me get by. The next year was no better. Several colleagues with good prospects left the firm and the industry for good. We learned that strong pay-for-performance compensation incentives could cut both ways.
Many wondered if that was still the case last week, when New York State Comptroller Thomas DiNapoli released an estimate that the "securities industry" paid its New York City employees bonuses of $18 billion in 2008, leading to a public outcry. Lost in the denunciations were the powerful benefits of the bonus system, which helped make the U.S. the global leader in financial services for decades. Bonuses are an important and necessary part of the fast-moving, high-pressure industry, and its employees flourish with strong performance incentives.
There is also a fundamental misunderstanding of how bonuses are paid that is further inflaming public opinion. The system has become more complex than most people know, and involves forms of bonuses that are not entirely discretionary.
The anger at Wall Street only grew at the news that Merrill Lynch, after reporting $15 billion of losses, had rushed to pay $4 billion in bonuses on the eve of its merger with Bank of America. Because Merrill Lynch and Bank of America were receiving substantial government funds to keep them afloat, the subject became part of the public business. The idea that the banks had paid out taxpayers' funds in undeserved bonuses to employees, together with a leaked report of John Thain's spending $1 million to redecorate his office, understandably provoked a blast of public outrage against Wall Street. The issue was so hot that President Barack Obama interrupted his duties to call the bonuses "shameful" and the "height of irresponsibility." Then, on Wednesday, he announced a new set of rules for those seeking "exceptional" assistance from the Troubled Asset Relief Program in the future that would limit cash compensation to $500,000 and restrict severance pay and frills, perks and boondoggles.
Lindsay Holmes
In the excitement some of the facts got mixed up. Mr. DiNapoli's estimate included many firms that were not involved with the bailout, and only a few that were. Merrill's actions were approved by its board early in December and consented to by Bank of America. But the basic point is that, despite the dreadful year that Wall Street experienced in 2008, some questionable bonuses were paid to already well-off employees, and that set off the outrage.
Many Americans believe that any bonuses for top executives paid by rescued banks would constitute "excess compensation," a phrase used by Mr. Obama. But no Wall Street CEO taking federal money received a bonus in 2008, and the same was true for most of their senior colleagues. Not only did those responsible receive no bonuses, the value of the stock in their companies paid to them as part of prior-year bonuses dropped by 70% or more, leaving them, collectively, with billions of dollars of unrealized losses.
That's pay for performance, isn't it?
"Wall Street" has always been the quintessential, if ill-defined, symbol of American capitalism. In reality, Wall Street today includes many large banks, investment groups and other institutions, some not even located in the U.S. It has become a euphemism for the global capital markets industry -- one in which the combined market value of all stocks and bonds outstanding in the world topped $140 trillion at the end of 2007. Well less than half of the value of this combined market value is represented by American securities, but American banks lead the world in its origination and distribution. Wall Street is one of America's great export industries.
The market thrives on locating new opportunities, providing innovation and a willingness to take risks. It is also, regrettably, subject to what the economist John Maynard Keynes called "animal spirits," the psychological factors that make markets irrational when going up or down. For example, America has enjoyed a bonus it didn't deserve in its free-wheeling participation in the housing market, before it became a bubble. Despite great efforts by regulators to manage systemic risk, there have been market failures. The causes of the current market failure, which is the real object of the public anger, go well beyond the Wall Street compensation system -- but compensation has been one of them.
The capital-markets industry operates in a very sophisticated and competitive environment, one that responds best to strong performance incentives. People who flourish in this environment are those who want to be paid and advanced based on their individual and their team's performance, and are willing to take the risk that they might be displaced by someone better or that mistakes or downturns may cause them to be laid off or their firms to fail. Indeed, since 1970, 28 major banks or investment banks have failed or been taken up into mergers, and thousands have come and gone into the industry without making much money. Those that have survived the changing fortunes of the industry have done very well -- so well, in fact, that they appear to have become symbolic of greedy and reckless behavior.
The Wall Street compensation system has evolved from the 1970s, when most of the firms were private partnerships, owned by partners who paid out a designated share of the firm's profits to nonpartner employees while dividing up the rest for themselves. The nonpartners had to earn their keep every year, but the partners' percentage ownerships in the firms were also reset every year or two. On the whole, everyone's performance was continuously evaluated and rewarded or penalized. The system provided great incentives to create profits, but also, because the partners' own money was involved, to avoid great risk.
The industry became much more competitive when commercial banks were allowed into it. The competition tended to commoditize the basic fee businesses, and drove firms more deeply into trading. As improving technologies created great arrays of new instruments to be traded, the partnerships went public to gain access to larger funding sources, and to spread out the risks of the business. As they did so, each firm tried to maintain its partnership "culture" and compensation system as best it could, but it was difficult to do so.
In time there was significant erosion of the simple principles of the partnership days. Compensation for top managers followed the trend into excess set by other public companies. Competition for talent made recruitment and retention more difficult and thus tilted negotiating power further in favor of stars. Henry Paulson, when he was CEO of Goldman Sachs, once remarked that Wall Street was like other businesses, where 80% of the profits were provided by 20% of the people, but the 20% changed a lot from year to year and market to market. You had to pay everyone well because you never knew what next year would bring, and because there was always someone trying to poach your best trained people, whom you didn't want to lose even if they were not superstars. Consequently, bonuses in general became more automatic and less tied to superior performance. Compensation became the industry's largest expense, accounting for about 50% of net revenues. Warren Buffett, when he was an investor in Salomon Brothers in the late 1980s, once noted that he wasn't sure why anyone wanted to be an investor in a business where management took out half the revenues before shareholders got anything. But he recently invested $5 billion in Goldman Sachs, so he must have gotten over the problem.
As firms became part of large, conglomerate financial institutions, the sense of being a part of a special cohort of similarly acculturated colleagues was lost, and the performance of shares and options in giant multi-line holding companies rarely correlated with an individual's idea of his own performance over time. Nevertheless, the system as a whole worked reasonably well for years in providing rewards for success and penalties for failures, and still works even in difficult markets such as this one.
At junior levels, bonuses tend to be based on how well the individual is seen to be developing. As employees progress, their compensation is based less on individual performance and more on their role as a manager or team leader. For all professional employees the annual bonus represents a very large amount of the person's take-home pay. At the middle levels, bonuses are set after firm-wide, interdepartmental negotiation sessions that attempt to allocate the firm's compensation pool based on a combination of performance and potential.
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.
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