inside the meltdown

Adam Davidson

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An international business and economics correspondent for National Public Radio, he's editorial director of NPR's multimedia project Planet Money. This is the edited transcript of an interview conducted on Nov. 13, 2008.

“If we were shooting the horror movie, the first sign something is going wrong would have been in 2006. It would have been in the office of someone in the mortgage industry...”

[Alan Greenspan, retiring as chairman of the Federal Reserve, is praised as the "maestro."] What didn't the people praising him know about Alan Greenspan? ...

They didn't know that Alan Greenspan had made money either free or even less than free. He had turned on a fire hose under the U.S. economy that was pushing money and investment really fast to lots and lots of places where it hadn't gone before by keeping the interest rates at this 1 percent level for such a long period of time.

They also didn't know that there was a hot debate going on at that time ... among academic economists that maybe the Fed should also be paying attention to assets, which at that time meant home prices, ... and should worry when home prices go up too fast, because the Fed is supposed to fight inflation. Alan Greenspan was absolutely [against that]. He just saw this entire debate as irrelevant. ...

Home prices for most of U.S. history had gone up at a roughly steady rate with income, and suddenly it's going up much faster than income at what now seems clearly unsustainable rates. And he was saying, "I don't care." ...

Is there a political philosophy that is the underpinning for where he's coming from?

... I think by his own description he had too much confidence in the market's ability to correct itself, particularly in this new universe. You certainly see that.

It seems that there can be too much of this binary idea: We should have regulation; we shouldn't have regulation. ... I think what we're seeing now is the whole regulatory apparatus was not prepared for this crisis, so "more or less" wasn't the right question to be asking. ...

We are brand new in this world of structured finance, and we had a regulatory apparatus, we had a Federal Reserve system, we had an entire financial oversight system built on a different model. ... I think Alan Greenspan, a lot of people were taking the logic of the old model and trying to apply it to this new world, and it didn't make sense. ...

[What is the shadow banking system?]

When I think about the financial system, and it gets so confusing, ... what I try and remind myself is really at the end of the day, there's some parts of the economy that have too much money and some parts of the economy that have too little money. ...

Someone has some extra money. ... They want their money to earn some money. And then there's people who want to do something, whether it's buy a TV or start a business or whatever it might be, and they don't have enough money, so they need to borrow money. ...

In the old system, a lot of the extra money was in the hands of individuals. ... They would put it in their bank as a savings account, and then the bank would amass billions of dollars from all these different people and lend it out to someone else. And the bank is making money off the difference in the interest rate. So the savers, [the bank is] giving them, say, 2 percent a year in interest, and they're lending it out to other people who are paying them 6 percent, and the bank gets 4 percent, and you're set. ...

In the shadow banking system, rather than put your money in a bank account, you're taking your money and you're actually buying a piece of a loan. It's in the form of bond or something. They call them bond-like or fixed-income instruments. Someone needs money, they used to go to the bank and sit down with the loan officer. ... Now they actually borrow money directly from the person with the extra capital, and they do this by selling them a piece of paper, a bond or commercial paper or CDO [collateralized debt obligation] or whatever. It's a fancy form of an IOU.

Everyone knew this was happening. ... But what built up, and what I don't think anyone really understood until the last year or two, is that this shadow system had become the way that capital is allocated in our capitalist system; that it's no longer a small number of guys with black suits and hammered hats doing very diligent, serious analysis of each loan. It was sort of a wide-open marketplace where the decisions about who gets to borrow money and who doesn't are not made by a sample of professionals with a very conservative lending philosophy; it's made by everybody. ...

It means investment banks matter more than commercial banks, because investment banks are much more part of the shadow banking system. It means hedge funds matter more. It means that more of the activity is unregulated. It's completely invisible to the governmental regulators.

If the whole thing had not collapsed, you would probably see it and think, oh, it's obviously better, because what we've learned about capitalism is that when a lot of people are evaluating something, they make a better decision than when a small number of people are evaluating something. ...

It turns out maybe that wasn't as right as we expected it to be, but it definitely made a lot of sense. You did not have to be an ideological zealot to believe that. ...

[One of the most significant among these new instruments are credit default swaps (CDS). What are they?]

Credit default swaps are like bond insurance. You hear bond insurance and think, what could be safer and more boring than that? ... But what smart financial engineers figured out in the last 10 years is that you can use bond insurance to make huge bets on companies.

Before these credit default swaps, let's say I thought when Ford sold bonds, that they were underpriced. … I could buy the bond for $100, and then let's say it's paying 6 percent; a year later I get $106. Who cares? Six bucks -- that's not a lot of money.

Now with this credit default swap, I can sell protection on Ford bonds. Because my view is Ford bonds are safer than most other people think, ... I don't think I'm going to have to pay it out. So you pay me $10, $20, $30, and I only have to put up a tiny bit of collateral. So I don't make $6 on $100; I might make $600 on $100, or $6,000 on $100. I can make much bigger bets using these.

It's unregulated. ... It's not actually insurance; it's just a private contract to pay money if a bond defaults. ... So there's no way, really, for the government or anyone else to know how many of these are out there, know how big a market it is, and know who owns them and who owes who money, because it's just a bunch of contracts in file cabinets in the lawyers' offices of banks and hedge funds all over the world.

So that's all good as long as Ford doesn't collapse.

It's actually problematic for a few reasons. The price of the CDS is based on how the company is doing any given day. So let's say tomorrow Ford does a little worse, protection is going to cost more, and the spread widens.

What usually happens is I sell you the [protection], but I want protection, so the next day I buy protection. And the guy I buy it from buys it from someone else, and buys it from someone else. And you have this chain that might very rapidly take you from New York to Amsterdam to Shanghai to Frankfurt to London to Abu Dhabi. ... If any one of those goes out of business, then suddenly everyone else isn't quite clear on who owes them money and how they're going to get the money. And that's how it spreads a problem so rapidly.

... How did it go from the subprime mortgages into the CDOs we're talking about?

Originally [CDOs] were baskets of all sorts of things. So any one CDO would have airplane loans and credit card debt and student loans, office buildings and all sorts of things built in. And then quickly they started making them more than one class. … [A CDO] is usually a company created inside of a hedge fund or an investment bank. You create a new company, legal fiction really, but a new company that owns a bunch of assets that pay a regular -- monthly or twice-annual or whatever -- payment stream. And then the CDO is a way to spread that money that comes in to different people out in the world, the investors who invest in it.

Like any investment, the safer you are, the less return you get. So you can say, "I want to be the first guy to get paid each month." Well, OK, you can be the first in line, but that means we're only going to give you 2 percent for your $100. You might say, "I don't want 2 percent; I want to make a big return." All right, you're last in line to get paid. And if everyone pays their mortgage each month ... you'll get 20 percent back. So you'll make a lot of money. But you're last in line, so if five people stop paying their loans, you don't get anything. ...

The problem is how they rated the risk. The theory is any one CDO owned mortgages from all over the country. So if the mortgages from Southern California do badly, we'll have the mortgages from Florida that will do well and we'll have the mortgages from New York that will do well, so we're diversified. ...

What didn't seem to be built into the model was the idea that, what happens if the whole market, all homes everywhere, suffer a fall? ... We don't really mind that the high-risk folks didn't get paid, because they were taking a big risk. They accounted for that risk, and they were prepared. It's the low-risk folks not getting paid, that's what makes it a toxic asset. It's an asset that you built into your bank like you had a guarantee, and now you don't have that money. And that is what starts making healthy banks turn into unhealthy banks.

[Why didn't regulators catch that potential danger before banks started selling these products?]

... When they create new products, investment bankers, ... one of the things they're doing is studying regulation. They want to find the crevices and cracks that regulation leaves open to allow them to take on whatever risk they want to take on. ... They don't want the government deciding. This is not an ideological move. It's just they want to create the exact product that their customer wants. …

One way to picture what happened between 2000 and 2006 is that there's all this new money looking for a home to invest. ... And the places that were overlooked by regulators, ... the financial assets are pouring into those, and you get these bubbles of investment right in those places. So when you see credit default swaps which are entirely unregulated, CDOs which are lightly regulated, you see it there. Investment banks, which are less regulated than commercial banks, you see money pouring into them. ...

So these bubbles appear, and then poof, they blow up. ...

... What are the first tremors people feel, and how do they feel them?

If we were shooting the horror movie, the first sign that something is going wrong would have been in 2006. It would have been in the office of someone in the mortgage industry who's starting to see people defaulting on their mortgages in the first month that the mortgage was issued, which almost never happens. You're seeing people getting these crazy teaser rates in adjustable rate mortgages who can't afford the first month of the ridiculously low teaser rate. ... You're starting to see mortgage industry insiders beginning to slow down this ravenous hunger for mortgages that led us to give mortgages to people who never qualified for them in the past.

This very quickly means fewer homes are being bought, and prices are beginning to decline in certain parts of the market. ... To people who knew what to look for, [this] is beginning to set off alarm bells that this subprime housing machinery is breaking down. ...

Then you see I guess a year and a quarter of things happening that could credibly be called isolated events, ... things happen that never happened before but aren't totally terrifying. You see that first Bear Stearns fund blow up [in March 2007], and Bear Stearns have to come in and rescue it. Then you see the second fund blow up.

The thing that starts happening, especially in August 2007, where people really start opening their eyes and thinking, huh, something weird is going on, is the TED [Treasury-EuroDollar] spread starts to skyrocket up.

[Why is that significant?]

... The TED spread is a good proxy. It's a good way of measuring how anxious the world economy is. ...

With the TED spread, you usually use three-month Treasury bonds. You're lending your money to the U.S. government for three months, and you feel pretty much 100 percent certain [that] in three months the U.S. government is going to be in a position to pay you back. So that's seen as sort of the base of the whole global risk system. Nothing should be cheaper than that, because nothing is less risky.

But pretty close to the second least risky thing is banks lending money to other banks for a period of something like three months. And the rate we use there is LIBOR, ... the London Interbank Offered Rate. ... If one major top bank in the world wants to lend money for three months to another major top bank in the world, that's the rate that they do it at. ...

The TED spread is the distance between the Treasury rate and the LIBOR rate. That should be very small, because that should just be the tiny bit of additional risk between the U.S. government and one of the top banks in the world. It's mostly been, for the last several years before this time, around 20 basis points, which means 0.2 percent, very little daylight between these two rates. Most of its history I think [it's been] around 50 basis points -- very small, very close together. And suddenly it starts skyrocketing up.

In August of '07.

In August of '07. ... It's close to unprecedented. In the past you would see it spike, and then it would come down right away. But it's sustaining that high, high level. And that's telling you that banks are not lending money to other banks unless they're really coaxed into it by giving them a lot of money in return.

And that for sure is beginning to scare the Treasury secretary, the Fed chairman, lots of market players. This is the base of capitalism; this is the base of our financial system: banks lending money to other banks. ...

So that's a much bigger deal than one fund at Bear Stearns and then another fund at Bear Stearns blowing up. ... When you start seeing that regular banks borrowing and lending from other regular banks are getting nervous, that's making everyone a bit more nervous.

What's making them nervous? Why is this happening? ...

I forget when the phrase "systemic crisis" became common; it would have been somewhere around then. In my lifetime, in Alan Greenspan's lifetime, we have not seen a systemic crisis, meaning the whole system at risk for breaking down. And just being able to raise that question, just being able to wonder if we have systemic risk, that is terrifying. ... What is the risk that the whole system will break? ... I don't know if anyone really even knew what to picture. I think we learned what to picture in September and October of '08. ...

But by August '07, systemic risk is at least a question mark that begins to form. ...

Exactly. ... It's still an extremist position. ... I forget when The Wall Street Journal [reported] a majority of economists even thought we had a recession risk. ... It was much later in '07. It might have even been early '08. ...

And certainly the government in Washington --

They were explicitly saying that this is under control; this is manageable. …

What I imagined would bring down a systemic crisis is a really big thing, a nuclear bomb. It didn't feel like the subprime housing market was a financial nuclear bomb. ...

What is still just conceptually really hard to understand was how that system undergirded so much of the rest of capitalism, so much of the rest of the financial system. ... There were people who saw that the problem was bigger than we thought. I don't know of anyone who really saw that the system itself would break down in this way. ...

I think of someone who goes to the doctor because they broke their wrist, and the doctor is looking at their body, and the blood is not moving. The blood has just stayed wherever it is. The heart is beating, everything seems to be functioning, but blood is staying still. They don't have any way to think about it. There's no precedent; there's no ability [to conceptualize it]. Money doesn't move. We were not there. I don't know anyone who was there until it really happened.

So it's the spring [2008]. Let's put ourselves, to the extent that we can, in [then-Treasury] Secretary Paulson's chair. First, who is Paulson? ...

Henry Paulson was as close as you could get [to being] the king of Wall Street, the single most important player on Wall Street. He ran Goldman Sachs, the most storied, respected of the investment banks. He was known as "the bulldog," this really opinionated guy who went with his gut and went with it with full gusto and was part of this just behemoth of moneymaking. ... Paulson is not a guy who spent a lot of time with the geeks building the complicated structured financial instruments. ...

There were rumors that [Paulson] might be Treasury secretary. And if I remember, the smart word on the street was absolutely not. This is actually a man for whom Treasury secretary would be a step down in power and influence. ... This is one of the few people in America who you feel could really sit down with the president of the United States and start dictating what he needs before he takes a Cabinet-level position. ...

It was sort of a puzzle, a head scratcher. Why did this guy take this job? ... I remember talking to one person who said the president must have just pulled the "I'm your president; you've got to do what the president says" card. And Paulson finally decided, OK, I'll do it.

When he went to Washington, that seemed to be the case. It didn't seem to be the case that he had gone with a deal, because he didn't do much. He was a boring Treasury secretary. ... And then the crisis hits, and really all eyes were on Ben Bernanke as the guy who matters. ...

… Who is Bernanke? And how is he different than Paulson?

... Apparently he's a loyal Republican, or a longtime Republican, but he's just solid. He's the guy you want in the job. He was probably the smartest academic economist of the federal banking system, of central banking in general. ... There's no ideology there. This is just a well-respected pragmatist. And what he famously knows is the Great Depression. ... He's also an expert on the Japanese financial crisis. You can't think of anyone who would be more solid than this guy. And it was seen as a really good choice. ...

It's easy to contrast the two men, Henry Paulson and Ben Bernanke, this kind of headstrong, tall, bold bulldog in Henry Paulson and the much softer, quieter, bookish Bernanke. There's no question that in any discussion Bernanke's going to be more thoughtful. He's probably going to be more right. ... And it's not that Bernanke necessarily knew all of the details of some of the more obscure and brand-new structured products, but he understood as well as anyone alive how money flows through a system and what the crucial role of a central bank is in that process, and what happens when it breaks down.

[Spring of 2008, Bear Stearns collapses. Paulson] brokers a marriage that gets Bear Stearns together with JPMorgan. When you see that happening, what does that say to you?

... Bear Stearns collapses, and there's an inherent distaste for what happened. Was it a bailout? Was it not a bailout? ... It becomes very hard to understand what Paulson is up to. ... I felt so much anger from friends and from listeners calling and e-mailing: "Oh, man, the fix is in. They're just helping their buddies stay rich. This is horrible."

I didn't think that was happening. I thought, Henry Paulson in his gut believes in capitalism and believes that you have to let bad institutions fail; that clearly he was spooked. But even then it still felt like maybe this was a one-off, that this was not the beginning of the systemic crisis. …

It's not that they were worthless like Lehman Brothers turned out to be; it's just that they couldn't get money to get them through that week. ... That was shocking, to see that it was basically a bank run, a shadow banking system bank run as opposed to the old bank run, where nobody is going to lend them money overnight because nobody wants to be the last guy to lend them money and lose it all. So seeing that speed and ferocity was definitely new. You picture more like a GM or a Ford, these huge companies dying over the course of decades, not hours. ...

[2008 was the summer of assurances. CEOs, the government, everyone's saying it's going to be OK.] Were they lying? ...

I definitely don't think they were lying in the classic sense of the word. I think they were nervous. There was a lot of real worry and a lot of hope. ... And I think that certainly Ben Bernanke, and I'd say Paulson, too, took very seriously the bully-pulpit role of their position. When you're Fed chairman or Treasury secretary, ... you learn very quickly that a misplaced word here or there sends markets hurtling one way or the other. ...

The TED spread was going down at some point. And things felt like they were going back to normal ... post-Bear Stearns. It wasn't a one-way trajectory. ... It was still very common to talk about decoupling, which is this idea that the U.S. could go in a slowdown, and Europe and Asia could not; that there wouldn't be a global recession. ...

[But that thinking doesn't account for contagion.] What is the contagion?

There's sort of [four] contagions. In the old banking system, if you go back far enough, you could have a Brooklyn recession and a Queens growth period. Or you could even have a 78th Street recession and an 82nd Street growth, because the banks really were local. ...

The new system, the shadow banking system, you have this global pool of money. ... You have these mutual funds and pension funds and insurance companies, which of course are just all of our money pooled into one big fund. But you have TIAA-CREF with half a trillion dollars and Fidelity money market funds with trillions of dollars. And they don't have to make a profound decision. They don't have to sit there and go, let's bring down Japan, or let's destroy Hungary. They just get a little nervous and they say, I'm a little nervous about Hungary; let's move to a different part of Europe. … And enough of them make the same decision at the same time, and the impact is cataclysmic. ...

So this global class of investors ... all over the world is tied; it's linked. If an investor in Switzerland is worried about Thailand and switches their money to Korea, it affects an investor in Brazil. ...

And then the other part of the contagion is the actual subprime-related assets. The other big glossary word is "leverage," which defined this bubble period so much. It's not just borrowing. If you borrow $100,000 to buy a house, that's borrowing. If you borrow $100,000 to buy a million dollars' worth of homes and then you flip them, that's leverage. You have a base of capital and you build sort of a house of cards. And what we learned is the base was built disturbingly often on these subprime structured credit products.

To understand why that spread so far, because it kind of doesn't make sense -- why would banks in Switzerland and Japan and Brazil be so focused on homes owned by poor people in America? But you have to see what happened between 2000 and 2007. ... It took humankind centuries to get to $36 trillion, and then it took us six or seven years to double that. And in no time at all there's twice as much money looking for something to invest in, but there aren't twice as many businesses and factories to invest in. They had to find something new. One of the things that was growing the fastest and attracting the most investment was the subprime housing market in the U.S. And then you create these leveraged products off of it, so a billion dollars of subprime loans can support $10 billion worth of structured products. Then you create these credit default swaps on top of those. And suddenly that $10 billion that really is based on $1 billion is actually supporting $100 billion worth of investments elsewhere.

And that actually would have been OK ... if they'd seen it as long-shot bets. ... But what they did was they took this stuff and used it as the building blocks on which they built their financial empires. ... And that means that when that stuff starts breaking, just huge pillars of the financial system break as those bricks are pulled out. And that's the [second] contagion. ...

The third would be these credit default swaps and these completely opaque, confusing bets that different financial institutions made on the health of other financial institutions and other financial products. The subprime housing crisis, if that's the flu, then the credit default swaps are the sneeze that spread the flu very quickly around the world.

And then, there's a fourth contagion which is just all of this, meaning there's less money in the world, meaning there's less money to lend, meaning the real world starts firing people, laying people off, people stop buying stuff. And then there's a real-world recession, and that just makes everything else that's happening worse. ...

[But] by August of this year, by Labor Day of this year, we don't know about any of that really.

... And then Sept. 6, I guess, Fannie Mae and Freddie Mac needed a rescue. That was the first thing that you saw. If Fannie Mae and Freddie Mac hadn't been saved, I remember one guy, a former Treasury official, saying to me explicitly, "Global capitalism would have ended; it would have ceased," because Fannie Mae and Freddie Mac represent something like $5 trillion of bonds that undergird a huge portion of the global financial system. They're seen as almost as safe as U.S. Treasuries, almost the same as a U.S. Treasury [bill]. And you would have just seen a complete seizing up of capital markets.

I remember that was the week that felt the most like coming back from Iraq on vacation. That was the week where I felt like I was in a different place than everyone else I knew in my life, because I was seeing the collapse of our way of life as a real possibility. ... I saw not just a slowly increasing number of economists saying it; I saw everybody saying it. ... That was the week I personally was scared. ... I think that was the week that I realized that it's truly possible for money to stop moving. ...

[The weekend that Lehman is going under,] do you know that weekend that it's happening?

No. There's that weird thing that Bank of America was going to buy them, and then [at] the last minute they buy Merrill, and Lehman goes away. And we're getting hints of just what a dog Lehman was. ...

I felt kind of good that they hadn't bailed them out. I remember for a moment feeling like, oh, good, yeah, let's not bail out everybody. We've got to let one or two of these collapse to show what this means.

Moral hazard.

Yeah. Capitalism requires failure. Capitalism is a lot about failure. You need to allow failure. And I learned a lot more than I did about the commercial paper market that week, and the interbank lending market that week. Really I don't think it was until Wednesday that we really saw, oh, goodness, the economy came close to dying.

I was joking with some friends that the economy was legally dead for a few hours Wednesday and Thursday before the plan to have a bailout plan was announced. And that was the famous day that Paulson and Bernanke have this off-the-record conversation with Congress, and say -- the reports we hear is they said things like -- Bernanke, the Great Depression scholar, saying, "We won't even discuss the Great Depression after this, because this is much worse than the Great Depression."

I remember that week just trying to get my head around what are we talking about, and calling people and saying: "Are we talking about, like, no money, no barter system? What are we talking about?" And people saying: "No, there would be money. It wouldn't be much in the way of lending and borrowing, and that's what our economy is built on." And, "How long will it take to sort itself out?" "We don't know. Nothing like that has ever happened before."

I keep thinking of, like, [until] you have a plumbing problem at home, you never think about your plumbing. ... That was the week where I really got a crash course in the commercial paper and interbank lending market. [Prior to that week] I think I could have defined them; I think I could have vaguely told you what they were. But when something like that breaks, that is the cessation of a crucial part of capitalism. And that was really stunning.

[When the government let Lehman fall, did they not anticipate those problems with commercial paper and interbank lending?] What did they miss ... ?

... It was irresponsible not to expect some de-leveraging, some housing-price fall. It was not necessarily irresponsible not to see this. What happened was as Lehman was in trouble, and I was calling around talking to people and saying, "What are the systemic risks?" ... They were saying, "Well, look, everyone has known Lehman is the next one up, the most risky one." So anybody who has any exposure to Lehman is lessening their exposure. They've spent the entire summer making sure that a Lehman collapse can't hurt them.

So I went to bed Sunday thinking, oh, OK, Lehman can collapse, and it really isn't that big a deal. And we are being told the Fed and others have been looking over the Lehman books very carefully. ...

The shock was that [mutual fund] the Reserve Fund had this big exposure to Lehman. And to this day I don't think anyone can quite understand how the oldest and one of the most respected conservative money market mutual funds would have that much exposure to Lehman. It does seem nuts. It seems irresponsible and nuts. ...

So when does it dawn on everybody about the Reserve Fund and [interbank lending]?

The Reserve Fund breaks the buck on Tuesday. And then Wednesday we're seeing people just pouring money out of the interbank lending market and the commercial paper market.

This is the easiest part of capitalism. This is the short-term money that any large business that has a little money left over in its wallet at the end of the workday lends to the businesses that don't [have money] for one day or one week or two weeks or whatever. And that just ends. ... We're seeing nobody able to get a loan, these short-term loans; the safest companies in the world, the most rock-solid banks in the world, unable to borrow money; ... no confidence in the system itself. ...

This is your thing you were saying about no blood flowing through the body. ...

... What starts turning a recession into something worse is when good ideas can't get money, good businesses can't get money. ... The Google of 2020 isn't getting its startup financing even though everyone thinks it's a good idea; everyone thinks it's a solid investment. But just the system itself is broken, and they don't get money. And that's not just a problem through this week. ... That means our economy isn't going to grow for a long time.

That's what we started to see. And very quickly it started affecting municipal bonds. So you start seeing cities and counties and school districts and hospitals unable to borrow money to run their basic services. That's where it starts really affecting us. ...

And so in this ugly period, what is the government doing? When does the government finally get around to this notion of a bailout? ...

... I'd say all of 2008 it was in the air. And some people were calling for it: "Oh, the government should just buy all these toxic assets and just solve the problem." That's a disgusting idea in a lot of ways. ... It should be that if you invest a lot of money in really lousy junk, and it goes from being worth $100 to being worth $8, then sorry, sucker, you lost $92. And that's good. We want you to lose $92. That's a good thing. ...

Everyone says, "There's no market price [for these toxic assets]." There was a market price. It was just a very, very low market price. ... The banks that held onto it weren't willing to sell it at 8 cents on the dollar. They wanted, say, 60 cents on the dollar. And there's something kind of gross and disgusting about the idea of the government coming in somewhere in between and basically subsidizing foolishness, subsidizing risky behavior that could bring down the whole economy. ...

So I think things needed to get this bad for that to be even remotely a political reality. I don't know, but we were told that Henry Paulson himself found this a very noxious idea. And there's a lot of talk about Japan, that what Japan did wrong was bail out sick banks and keep these zombie banks alive, banks that had no business being alive; then they just become a suck on the government's money. ...

But it was that Wednesday-Thursday, and then that Friday morning when they actually announced they're going to ask for the money. ... In a weird way, that initial three-page Paulson plan made my job a lot easier, because it was so ridiculous. It was just, we're going to give this guy absolute power, and no one is allowed to ask any questions. ... I found it a real bizarrely tone-deaf political move. ...

[What was the process that led to the passage of TARP, the Troubled Asset Relief Program?]

... The leading economists in the country are suddenly just weighing in and having these big, interesting debates in public about this bill. ... A majority agreed that it was a much better plan for the government not to buy these toxic assets, but to directly give money to the banks. ... It was striking to me that left-wingers and right-wingers, Democrats and Republicans, Libertarians and Keynesians and everyone in between seemed to agree. ...

And Congress was doing something else. And I'm kind of used to it. I'm used to there being an economically smart thing and Congress doing something else. But you would think at this time of all times, do the right thing. ...

So the Senate bill passes, and I'm sort of assuming that ... the U.S. government is going to be in the buying-of-toxic-asset[s] business, and I'm going to be in the covering-the-U.S.-government-buying-toxic-assets business. And I am frustrated that there's not this kind of public discussion on Capitol Hill, and that at least this stock-injection plan isn't being considered. ...

Thursday night I was driving home at midnight from a long day working on some radio stories, and I get a call from this economist who says, "It looks like it's in there," [meaning] the stock-injection plan; that it's actually in the Senate bill and it's in the House bill that will pass tomorrow. ... I go home, and I look at the sections, and I'm thinking, I'm not a lawyer, but this is not in there. I don't believe it. ...

And it was early [the next] afternoon when I started feeling very confident, and eventually I got confirmation from some senatorial and congressional officers; I got confirmation from some major bank lobbyists. And I was like, oh, OK, it's in there. ... But even then it was going to be a small part of the tool kit, not the main thrust of the tool kit. ... Now it's all that we're doing. ...

[Did the Fed and Treasury Department have differing views on the bailout?]

... Bernanke looked at this as an economics problem, looked at, what is the optimal economic solution? And that was the capital-injection plan. Historically and internationally, that has worked better. It makes more economic sense.

Paulson looked at it and said: "Well, wait a second. The bank lobbyists don't want it. They want the asset plan, and if the bank lobbyists are against us ... it will be much harder for us to get something through Congress if we go for the stock-injection plan as opposed to the asset purchase plan."

And also I think Paulson -- not only for him, for a lot of people -- there's something about the U.S. government owning shares in private banks that is just awful; it's disgusting. And I think Bernanke, in his heart of hearts I'm sure doesn't think it's ideal, but he's looking at it as solving a large economic problem and this being an acceptable intermediate solution. ...

[Is there a tension between the roles of the Federal Reserve and the Treasury?]

... Paulson and Bernanke, their personalities really represent the difference between these institutions. You expect the Treasury secretary to be more of kind of a heavy, pushing his administration's policies. ... And you want the Fed to have more like Bernanke's personality: soft, contemplative, very deeply aware of history, deeply aware of long-term potential risks, not so eager to see results in the next few weeks or months, but comfortable with the idea that his actions will have an impact for years, not hours or days. ...

The rumors or the things you hear is that there is a fair amount of tension, but both sides have agreed to give a very unified public face, because whatever specific issues they're battling over, it's more important that the American people feel that there's a unified agreement among the leadership. ... There's no possible way that these two institutions would see this in the same way. They shouldn't. If they see it in the same way, at least one of them is not doing their job correctly. ...

[You told me that the banks were like a casino owner who decides to play at his own tables.] What did you mean by that?

... An investment bank makes money by basically creating a product. They don't create a car or a bicycle; they create stocks and bonds, and they sell them. Or someone else creates them and they pass them through. But you're not taking a position; you're not taking a view on whether this bond or this stock is going to go up or go down. You're just selling it, and you collect a nickel for every one you sell. So it's pretty low-risk. ...

[The only] problem is when you own the stuff yourself. And to me it's kind of like being a casino owner. If you run a casino, whether people are playing poker or blackjack or whatever, if you get the odds right, they're making money, they're losing money; you don't care because you get 3 cents for every dollar they're betting one way or the other. ...

The investment bank started noticing that some of their customers were making a lot of money off this subprime housing stuff. ... And the investment bank started thinking, huh, maybe we should sit at the table. Maybe we should put 100 bucks on red and get 1,000 bucks, rather than 3 cents on the dollar.

Now, this happened, as far as I know, for a few reasons. One reason is they actually saw this as an incredibl[y] lucrative activity, and they had convinced themselves that they had ... figured out how to measure risk so precisely that it became impossible almost for them to lose money.

Secondly, when you're an investment bank, if you're selling what everyone else is selling, ... you just make a very small amount. But if you have something no one else has, you can charge a lot more. ... Investment banks have always known this, but because of technology, because of a whole host of factors, they have been creating new products much more quickly than they used to. And the thing is, when you first create it, you're not going to sell all of them, because nobody knows what they are. ... 2000-2007 is a period of such rapid financial innovation -- new financial products, these CDOs [collateralized debt obligations] and synthetic CDOs and other things coming out so fast that the banks just end up not being able to move them all out the door. ... You don't want to hold them, but you end up holding them. ...

So the investment banks are going from almost a guaranteed way to make money to taking, in the language of the markets, a directional position. They are saying if this goes up, we'll make a lot of money, and if this goes down, we'll lose a lot of money. ...

posted february 17, 2009

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