JIM LEHRER: Next, more scrutiny of the Federal Reserve and its role in the Bear Stearns deal. Jeffrey Brown begins our coverage with this report.
JEFFREY BROWN: Last month’s sale of ailing Wall Street giant Bear Stearns, facilitated in large part by the Federal Reserve, was again the center of attention on Capitol Hill today.
Officials spoke in front of the Senate Banking Committee. For Fed Chairman Ben Bernanke, it was a second straight day on the Hill to defend and explain his actions.
BEN BERNANKE, Federal Reserve chairman: I realize it’s not an easy sell sometimes, but the truth is that the benefits of our actions were not Bear Stearns and were not even principally Wall Street. It was Main Street.
We were concerned about other institutions. We were concerned about a variety of markets in which Bear Stearns participated. We were concerned about the thousands of counterparties whose positions would have become uncertain.
So we were — if you want to say we bailed out the market in general, I guess that’s true, but we felt that was necessary in the interest of the American economy.
JEFFREY BROWN: Bernanke was joined today by Christopher Cox, who chairs the Securities and Exchange Commission, Undersecretary of the Treasury Robert Steel, and Timothy Geithner, president of the Federal Reserve Bank of New York.
All three were involved in the Bear Stearns deal and were questioned in detail about the events after March 13th, when officials from the nation’s fifth-largest investment bank told federal regulators they were facing imminent bankruptcy.
The witnesses explained what happened during the round-the-clock negotiations that followed. Republican Senator Richard Shelby of Alabama.
SEN. RICHARD SHELBY (R), Alabama: Who first proposed using taxpayer funds to help finance JPMorgan Chase, its acquisition of Bear Stearns?
ROBERT STEEL, undersecretary of the Treasury: Late Saturday evening or early Sunday morning, it was proposed by one of the principals, JPMorgan, to President Geithner, that, so as to move forward, that this would be a condition that they seemed to be appropriate, seemed to be appropriate to them. And they proposed — so to answer your question specifically, proposed by JPMorgan Chase to President Geithner.
SEN. CHUCK SCHUMER (D), New York: Could a reasonable regulator have known and been ahead of the curve here? Should someone have called Bear in and said, “You need more capital, you need to reduce your exposure to mortgages”?
TIMOTHY GEITHNER, president, Federal Reserve Bank of New York: Very hard to know. I want to underscore — I’ll say very quickly, these things can happen incredibly quickly in markets like this.
What the world is going through and has gone through in the last nine months are truly extraordinary, described by many as the worst in 50 years, worst in a generation. So it’s very important to underscore that, because it’s easy to look back and say, “But doesn’t it look obvious?” And I think that’s somewhat unfair to the people…
JEFFREY BROWN: The hearing also addressed what could be done to prevent another Bear Stearns. Geithner argued Washington must increase its regulation of Wall Street.
TIMOTHY GEITHNER: We put in place almost a century ago a set of protections to reduce the risk to the economy that comes from runs on banks, but the system has changed a lot since then, and those protections do not extend to a set of institutions who are also vulnerable to liquidity pressures who also play a very important role in the economy.
And we’ve been trying to adapt our system to compensate for that change, but we’re going to have to think through very carefully a set of other changes in the future to get ourselves a better balance.
JEFFREY BROWN: A new Treasury Department proposal would give the Fed more power to monitor investment banks and others, but just how much clout the Fed would have is still to be determined.
Weighing the bailout decision
JEFFREY BROWN: In addition to the Fed's role in the Bear Stearns deal, concerns have also been raised about the central bank's decision to make emergency loans to investment banks. Today, the Fed reported it has lent those firms an average of $38 billion a day in the past week alone.
We look at all this now with Robert Reich, professor of public policy at the University of California-Berkeley. He served as secretary of labor in the Clinton administration.
And Vincent Reinhart, the former director of the Federal Reserve's Division of Monetary Affairs, he's now a resident scholar at the American Enterprise Institute in Washington.
Mr. Reinhart, you're one of -- you're among those folks who have raised questions about whether the Fed was right to step in to help rescue Bear Stearns. Why?
VINCENT REINHART, American Enterprise Institute: We have to recognize a couple of things. First, Bear Stearns is a middle-sized participant in financial markets. And by lending to Bear Stearns, the Federal Reserve has basically drawn a line that says, "Anybody at least as large, at least as complicated, potentially can borrow from the Federal Reserve."
JEFFREY BROWN: And so it could be on the hook to others?
VINCENT REINHART: And it formalized that by establishing a lending facility to investment banks. Essentially that means it's exposed its balance sheet to potential credit risk.
JEFFREY BROWN: Now, Mr. Reich, what do you think? We heard Ben Bernanke and the others say that they felt they had no choice.
ROBERT REICH, former U.S. labor secretary: I don't think they had much choice. They had to come up with an insurance policy against the possibility that nobody wants, and that is a run on the banks, where everybody loses confidence, and they say, "I'm not going to be able to get my money market fund or my pension fund. I have to take the money out and essentially put it under my pillow." That would bring the entire financial market to a collapse.
JEFFREY BROWN: Staying with you, how do you address -- one of the concerns raised is whether necessarily the Fed is promoting or helping out bad behavior.
ROBERT REICH: Well, it is in the sense that the Fed is now providing a backstop to every large financial institution and doesn't require much in return. That's why Hank Paulson has recently come up with a blueprint for the future, but even that blueprint is probably inadequate.
We've got to say that if taxpayers, essentially, are going to backstop big financial institutions that are not regular commercial banks, then the least we can require of these large investment banks and hedge funds is that they put up capital requirements, that they actually have to put up enough money proportional to the risks that they are taking on. Otherwise, the taxpayers are going to get caught holding the bag.
The changing role of the Fed
JEFFREY BROWN: Later this afternoon, Mr. Reinhart, when James Dimon, the head of JPMorgan testified, he said that they would not have acted without the Fed's help.
VINCENT REINHART: That's quite possible. Bear Stearns is a good-sized entity. It had very complicated positions, and Morgan didn't want to expand its balance sheet without having the security of a line of credit from the Federal Reserve.
JEFFREY BROWN: And if they had not stepped in, what would have happened?
VINCENT REINHART: You don't know. That's what's really hard about it. You don't know what -- if you're not in the room, if you weren't a part of those conversations, you can never be sure. So all of this is backseat driving.
JEFFREY BROWN: I want both of you to try to help us demystify the Fed here a little bit, because it is a good time to do that. You, Mr. Reinhart, wrote a recent op-ed piece in the Wall Street Journal called "Our Overextended Fed." And you said, "In the past few weeks, the Federal Reserve has fundamentally redefined the role of a central bank in a market economy."
VINCENT REINHART: Two sets of ways. In one, it's created new facilities where it essentially can expose its balance sheet and trade illiquid securities with market participants to make them useful temporarily. Those new facilities add up to about $400 billion, which is almost half the balance sheet of the Federal Reserve.
And the second way, by lending to investment banks or providing the facility to lend to investment banks, they've provided a backstop. And you have to believe that, if you can lend to an entity, you need to know the risks you're taking. And it's probably going to fundamentally change the regulatory framework.
JEFFREY BROWN: Mr. Reich, do you buy the idea that we are witnessing a redefinition?
ROBERT REICH: We are definitely witnessing a redefinition. We have not seen a banking system, a financial system, that looks like this.
In the 1930s, many of the regulations that were put into place really presided over a banking system that was much simpler. Now it is global. Now about 80 percent of new loans come out of institutions that are not traditional commercial banks.
And the Federal Reserve Board has become, de facto, a fourth branch of government, indeed, the most active branch of government when it comes to the current economic crisis.
Putting taxpayer money at risk
JEFFREY BROWN: It's also one of the least known branches -- if it is a branch of government, it's certainly one of the least known. So help us understand, what are the pros and cons, starting with you, Mr. Reich, of this new definition that we're witnessing?
ROBERT REICH: Well, the pros are we are in new financial territory, we've never been here before, and we need some institution with the expertise and the oversight to take action that needs to be taken to avoid the kinds of -- well, the kinds of runs on banks that almost occurred and would have occurred, many people think, if Bear Stearns had been let to go by itself.
The other new reality, though, is that we need some oversight of the overseers. We need an accountability mechanism. Because after all, at the end of the day, it is taxpayer money that is being put up here. Taxpayers are being exposed to huge potential liabilities.
And a lot of the investment bankers and hedge funds and all of their cousins really still, to this day, get all of the upside gains with regard to the bets they make, but very few of the downside losses, particularly if taxpayers are there as a backstop.
JEFFREY BROWN: How do you respond to that, the pros and cons that we all should know about?
VINCENT REINHART: So the main pro is the market needs liquidity, the Federal Reserve can provide liquidity. Recognize, however, that the Federal Reserve's programs are temporary.
So the Federal Reserve can plug a hole, but ultimately the core financial institutions that are at the center of the global trading system, they need more capital.
They have used too much leverage, that is, their balance sheet is too big relative to their capital base, and the Federal Reserve can't provide capital.
Increased government oversight
JEFFREY BROWN: Let me stop you there on that issue, because Timothy Geithner today, he was testifying, and he said that the Fed acted -- and this is about Bear Stearns -- in what was called, quote, "the classic tradition of lenders of last resort," end quote.
How deep are their pockets? How limited is their ability to be the lender of last resort?
VINCENT REINHART: So right now, the Federal Reserve balance sheet is a little bit under $900 billion, so they have a way to go. And, ultimately, a central bank that has a fiat currency -- that is just un-backed paper money -- can expand its balance sheet at will.
There are consequences for the macro economy down the road, but I wouldn't worry about the Federal Reserve running out of the ability to create money.
JEFFREY BROWN: When you create money, does that mean -- when you say "money," taxpayer money?
VINCENT REINHART: So you have to recognize, in doing it, it is putting its credit at risk and so that, if those loans don't get repaid, if the value of the loans that supported the Bear Stearns loan go down, the Federal Reserve will take a loss. And if the Federal Reserve takes a loss, that is less income that the Treasury will receive.
JEFFREY BROWN: What would you add to that, Mr. Reich, about the lender of last resort and whose money is at risk here?
ROBERT REICH: Well, it is taxpayer money eventually. And I think the Fed has got to do things, two things.
The administration, I think, has got to introduce legislation or Congress has got to do it to require that big banks that are backstopped by us taxpayers have to hold enough reserve, enough capital, their own capital, in proportion to the risks that they are taking. Otherwise, they get all the upside gains and have none of the downside losses.
And the second is that we taxpayers should get some of the upside gains, if we are going to put up our money. That is, I'm not suggesting we do anything as radical as Great Britain did, when it bailed out Northern Rock, a bank recently there that was heading downstream, just about to kind of ignite, implode, it was a big mortgage lender, and the British government not only bailed it out, but took it over, nationalized the bank.
Well, we're not going to do anything like that here. But we do, I think, have to think about ways in which, if we provide backstops, if we provide bailouts to big banks or even to mortgagees, we as taxpayers get some of the upside gains when those banks do much better, when the stocks eventually go up, or even when, say, housing prices go up, as well.
JEFFREY BROWN: Mr. Reinhart, to the extent that we're in uncharted territory here, you were at the Fed not that long ago. How much preparation for the kind of emergency situation that we rather suddenly get into, according to Mr. Geithner we just heard, and we've all just witnessed over the past six weeks or so, how much preparation for this kind of thing is there?
VINCENT REINHART: So I think a lesson learned from 9/11 was that it's a wise investment to do contingency planning, to have resources, to do war games, to ask, "What do you do next if this happens?"
And so, to some extent, some of the facilities the Federal Reserve has implemented were there on the shelf. They've been imaginative in transforming them in different directions, but they had people thinking about those issues.
JEFFREY BROWN: All right. Vincent Reinhart and Robert Reich, thank you both very much.
VINCENT REINHART: Thanks very much.
ROBERT REICH: Thanks very much, Jeff.