A partner at Sullivan & Cromwell, LLP, Rodgin Cohen is a top adviser to many major Wall Street firms. In the fall of 2008, as the financial crisis was at its peak, he was involved in a number of negotiations, including the failed attempts to find a buyer for Lehman Brothers, the federal government's takeover of Fannie Mae, the government's bailout of AIG, and Wells Fargo's purchase of Wachovia. Earlier in 2008, he also was involved in the negotiations that led to JPMorgan Chase's purchase of Bear Stearns. This is an edited transcript drawn from two interviews conducted on Dec. 1, 2011 and Dec. 29, 2012 by producers Martin Smith and Jim Gilmore.
In March '08 you get a call from the head of Bear Stearns.
... I would not have received a call at 9:30, 10:00 at night unless there was a major problem, and as he articulated it, it became clear that they were having serious funding difficulties. It had been very clear to me, since 1987, that an investment bank has a very short lifespan after it loses its liquidity. …
I said, "We need to talk to the president of the Reserve Bank." And they said, "We don't know him really well. Would you make the call?"
How did [then-President of the Federal Reserve Bank of New York] Tim Geithner react to your call? What did you say?
What I said was something like: "I think I know when there's a major problem brewing, and this is a major one. It needs to be dealt with very promptly." ...
These conversations always tend to be very much one-sided, where the regulator listens but doesn't give an immediate reaction. But he said something like, "Believe me, I'll be on it," and that really was the phone call. ...
When you're looking at [Bear Stearns], before the famous weekend, how vulnerable do you see them? ...
We saw the potential of real problems as early as the prior fall. Any financial institution which has that level of leverage is highly vulnerable whenever the marketplace loses confidence.
I certainly am not going to suggest that I saw the collapse in March, or any other data, but the vulnerability was there for some period of time. They were considered the weakest of the investment banks. …
You had arranged for an additional $30 billion to go to Bear. ... What was that about?
After the first set of negotiations, where we had talked about a price for Bear Stearns with JPMorgan Chase without any government assistance, by certainly late in the day on Saturday and turning into Sunday, Chase said that they were not prepared to do a transaction which included some of the more toxic assets at Bear Stearns.
So then there was an effort to come up with a methodology whereby Chase could get protection from the government on that $30 billion of assets.
So that $30 billion was paid for by the federal government.
It was Chase, if I remember correctly, took the first billion of the loss on the $30 billion. And the rest was the government's. …
What was the role of the New York [Federal Reserve Bank] to begin with, and how did Tim Geithner, as head of the New York Fed, view this? Were they surprised when they saw the hole that existed at Bear?
The New York Fed had only a limited supervisory role over Bear, so I think they were surprised at the depth and the suddenness, even more so the suddenness of the problems.
But I also think that Tim Geithner understood that it was a vulnerable situation. He had only limited ability to take certain actions. And my guess ... is that he was urging even more significant actions than others in Washington wanted.
... Explain that.
I think he was looking for a program or programs whereby the Fed could inject more liquidity into the financial services industry, away from just the banks. He had all sorts of power to inject liquidity with respect to the banks, but less power with respect to the non-bank financial institutions.
It's said that he was fearful or knowledgeable of the problems with derivatives, that he was very involved in trying to clean up the paperwork aspects of it. How much were they concerned about the realities of what the market had become?
... Way ahead, Reserve Bank President Geithner was worried about derivatives. But it was ... focused on the paperwork problem, the clearance problems. It was less focused on the incredible amount of gambling which had been introduced into the market, and the incredible amount of risk which had been introduced.
That is one of the saddest stories of the events leading up to the 2008 crisis, that no regulator, nowhere, had the information necessary to be as responsive as they ideally would have been. Derivatives were the heart of the problem. No one knew who had written them, how much had been written, and who were the recipients.
There wasn't the mechanism in place at that time. I believe that another clear source of the problem was that some of the biggest writers of derivatives were simply not regulated by the Federal Reserve in any way. These included primarily the so-called insurance monolines -- that's a misnomer, but that's what they were called -- the most egregious example of which being AIGFP [AIG Financial Products], but also was MBIA, Ambac and several others. ...
What led them to make the decisions that they did about Bear, to get so involved? Was fear of systemic risk the thing that motivated them? ...
... I think the overwhelming motivation was concern about systemic risk. This would have been the first major financial institution to collapse since Continental Illinois in the '80s.
No one knew. It again comes back to this lack of information. What would be the ramifications? Which other institutions were exposed? Which other institutions would suffer runs? I think it was the unknown that motivated this more than anything else.
... We've talked to a lot of people ... who say [the deal to rescue Bear] was the mistake of all the mistakes. What are your thoughts on that?
I would disagree that it was a mistake. ... The consequences of a failure at that point in time could have been catastrophic. You weigh those consequences against the consequences of the government assisting, which are not material, but on a risk/reward analysis it was clearly, in my view, the right thing to do.
Some will say what it did was take away the tool of threatening the moral hazard card from [Treasury Secretary Hank] Paulson.
When we talk about moral hazard, it's really important to separate it into what I think are its two components.
One is moral hazard of the type usually discussed, which involves the actions of a CEO and the board. I think after seeing what happened to Bear, no management, no board that had any degree of sense would have been encouraged that they could do whatever they would want to do and be saved by the government. Because from a stockholder perspective, from a personal wealth perspective, from a reputational perspective, Bear could not have been more damaging. ...
That leads to the second level of moral hazard, and that is the holders of liabilities. In that sense, the rescue of Bear might have given a false sense of confidence that the government would always be there. But again, it comes back to the risk/reward. Had you shattered the confidence of the liability holders at that time, one can't tell what the consequences could have been, but they could have been catastrophic.
... What was the effect of what happened as far as Bear to the rest of the financial sector, to the rest of Wall Street? ...
Bear had always been somewhat of an outlier, so there were those who said: Well I'm pleased; Bear got its comeuppance after all. The shareholders are basically wiped out. Management is displaced, etc.
I think the less emotional and more analytic people on Wall Street said: We are very pleased that the government did step in and that Chase stepped in, because we don't know what could have happened had Bear gone down.
... Basically [Wall] Street felt a bullet had been dodged.
The Street did believe that a bullet had been dodged with Bear, but I think the more analytical people in Wall Street recognized that there were still a lot of bullets coming, and they began to attempt to reduce their risk exposures. ...
... With this amazing crisis hitting, the moves that [Paulson] was making, were they viewed as the right moves? ...
Secretary Paulson was certainly far better known by Wall Street than either Geithner or [Federal Reserve Chairman Ben] Bernanke; after all, he had been CEO of Goldman Sachs. He was very highly regarded by his peers.
The general view was that he understood extremely well the financial situation, and importantly for a crisis, he was a very decisive individual. Those two qualities, I think, made the ideal person. If you go back, it's hard to think of who would have been his equal, much less his better. ...
... There's lots of talk out there that Paulson was trying to convince [Lehman Brothers Chairman and CEO Dick] Fuld to sell, but he didn't seem to be motivated enough. What was going on? ...
There almost seems to be a Rashomon-like quality to what was going on from the day Bear collapsed until September at Lehman.
From my perspective -- and this is when we first started to do substantial work with Lehman -- Dick Fuld and senior management were very concerned about being ... next on the chopping block. So there were numerous attempts to try and sell the company. Not just with the Koreans, which is the one that receives all the publicity, but there were feelers put out to any number of institutions, most of which were rejected automatically.
There was also the initiative to see if Lehman could become a bank holding company subject to Federal Reserve supervision, which ultimately is what happens for Goldman [Sachs] and Morgan Stanley. That didn't succeed.
So it was not as if Lehman was unaware, from my perspective. It was not as if they didn't try and take action to sell the company.
Then why did it happen? There were quite a few months in between the March events with Bear and the September events with Lehman Brothers.
... The source of the problem was in that environment, no major financial institution had a serious interest in acquiring Lehman. Again, there were conversations, and it usually was from the other side: We've thought about it. We're just not interested in pursuing it. It never got to a question of price, at least in the phone calls I had. ...
Describe Dick Fuld. ...
... He certainly had some of what I would call Wall Street characteristics, but I think the better ones.
He worked very hard. He was there first thing in the morning; he was there late at night. He was totally committed to trying to salvage Lehman. There's always a reference to Type A personalities in Wall Street. Dick Fuld was a Type A personality.
But some of the other portrayals I never saw. Some of these discussions could get heated all around. I never saw him really lose his temper. I never saw any of the screaming that you read about or hear about. He listened to advice. ...
Describe for me the moment in September 2008 when ... you get the news about the government is not going to bail [Lehman] out.
... I had the president with me. That was a devastating moment because what really happened was not that the U.S. government was unprepared to play a role, but that the British government was not going to permit Barclays to acquire Lehman. And that was the last chance.
Bank of America, which had been the other bidder, was clearly going another way at that point in acquiring Merrill Lynch. So with Barclays out of the running, there was no hope. That was probably the most devastating moment during the financial crisis.
Did you carry the news to Fuld?
The president and I went back to a conference room and immediately got on the phone. We weren't going to do it in front of everybody else.
We first tried, probably foolishly on my part, to talk to the British government. Since the secretary had not been successful, I should have probably figured out that I wouldn't be either. And I did make a phone call, and I was told the ship had sailed. ...
What we had been told was that the British government's response had been: We, the British government, are not going to permit the cancer in the United States financial system spreading to the United Kingdom.
I said that if Lehman fails, the cancer is going throughout the world. And I was told it was just too late. ... Then we got on the phone to Dick Fuld. ...
The decision to let Lehman fail -- what was your view, and what were the complications?
... Lehman's failure had unknown consequences, and you see this occur within 24 hours. I think if anyone had said ... that if Lehman failed, the largest money market mutual fund would fail within 24 hours, and that in turn would likely take down the entire money market mutual fund industry, there may have been second thoughts.
But I do want to come back to the question of was there a decision to let Lehman fail. I think the decision was that Lehman could be rescued without the government having to put in much, if anything, in terms of support. And the judgment that Lehman could be rescued was flawed -- not totally flawed, because in fact Paulson pushed the other banks to provide substantial support for Lehman, and they had committed to something in the neighborhood of $45 billion among them to support Lehman and to provide a foundation for Barclays to acquire Lehman.
But then the whole issue came up as to whether the British government would permit Barclays to proceed. … The specter of the Asian markets opening at 8:00 on Sunday night was the deadline. When it became clear about noon on Sunday that Barclays was not going to participate, there was no option left.
Why did it come down to this one weekend? Why hadn't they planned for this? ...
The failure to work out something in advance probably has several contributing factors. One, ... if you start talking about a rescue, you precipitate the need for a rescue. So I think there was a reluctance to be too aggressive in bringing the banks together, saying we need to save Lehman.
There's also a view that decisive action can only be prompted by a crisis, so you almost let a crisis go. I think maybe people had been given a false sense of optimism by the ability to save Bear. But there was no JPMorgan at this point.
One clear failure was of communication between the U.S. government and the British government, and perhaps the blame is equal on both sides. It's probably also to the private sector, because the private sector should have been encouraging the two governments to talk. I think there was probably a presumption in the private sector that the two governments were talking, which was clearly not the case until the very end.
So mistakes get made, and when you have to make decisions and take action within an extraordinarily confined period of time, the potential for those mistakes is multiplied.
When during the weekend is it clear that AIG was also going to be a huge problem?
It became clear by Saturday of the Lehman weekend that AIG was a huge problem, and that was, I believe, a total shock. ... Everybody was just thunderstruck by the demise of AIG.
... When was it clear just how damaging this could be? When did the credit markets start freezing over?
Because it was all happening together, it's somewhat difficult to distinguish what impact Lehman had, what impact AIG had. But certainly as word started to get around Saturday and Sunday about the depths of AIG's problems, that was having a huge impact.
If you even go back one week earlier when Fannie [Mae] and Freddie [Mac] failed and what, in my view, was probably the single-biggest error made in the whole crisis, to let the preferred stockholders be wiped out.
That also started to create a lot of deep concern in the credit markets, because the preferred stock was basically sold as the equivalent of debt, and if the preferred stockholders in Fannie and Freddie were going to be wiped out, then it was a baby step at most to wiping out debt holders elsewhere.
Take me to that weekend when they took over Fannie and Freddie. ...
I think it was a Friday morning when I received a call from Dan Mudd, the CEO of Fannie, saying he had been summoned to a meeting with Bernanke, Paulson, and the head of the regulatory agency for the GSEs, the government-sponsored entities, who was Jim Lockhart. ...
We pleaded that Fannie was deserving of better treatment then Freddie, because Fannie had gone out and raised a lot of capital. I'll never forget one of Secretary Paulson's lines; he said, "You may think that and we may even agree, but the Chinese don't know the difference between Fannie and Freddie," because they were both government-sponsored.
So they basically said: Get your board together, because we want you to be placed into conservatorship.
The reason why at that moment they made that decision?
It was principally that Fannie and Freddie were having enormous difficulty funding in the markets and the yield was starting to spike.
The short-term loans again were the problem.
Exactly right. ...
... Why were they so surprised at how big a problem AIG would become?
I think the surprise in the regulatory community about AIG was directly related to the lack of regulation of AIG Financial Products, which was not the only source of AIG's problems but was the most systemic source and I think truly the greatest source, just in terms of sheer magnitude of exposure.
It was an orphan in terms of regulation. ... Insurance tends to be very well regulated, particularly the big states have very strong insurance commissioners and departments and regulate well.
But it wasn't part of any of the insurance companies. It was stuck over in London. It was away from headquarters. The supervision, to the extent there was, went to the Office of Thrift Supervision, which had some very dedicated people, but almost no expertise in this area. ... So AIGFP was just off the radar screen for everyone.
Really had no regulator looking over the books.
No regulator with any expertise in the area. You didn't have the insurance commissioners, you didn't have the Fed, you didn't have the SEC [U.S. Securities and Exchange Commission]. ...
One of the other things that had come out of AIG afterwards that caused an enormous amount of anger when it was clearly understood was the fact that the counterparties weren't forced to take haircuts, that Geithner's plan was 100 cents on the dollar for Goldman and others. What's your view of why Geithner made that decision the way he made it? ...
... This was now in the midst of the worst part of the crisis. Lehman had failed. The Reserve [Primary] fund had failed. Fannie and Freddie had been in conservatorship. Here was AIG. Wachovia was in real trouble. So very decisive action needed to be taken, and decisive also means speed, by definition.
I assume the concern was that if Geithner had tried to negotiate -- and it wasn't Geithner's call alone; it was Treasury and the board of governors of the Federal Reserve system -- that some of the counterparties would have said no … and that there would have been then no rescue package.
The serious problem here was that AIGFP was guaranteed 100 percent by the parent company, so you couldn't let AIGFP go without the entire institution being in mortal danger. So I assume that was the reason. ...
... What's your overview of the extent to which the government and the Fed bailed out the banks at this point? If Bloomberg can be believed, the standing figure is $7.7 trillion.
I have tried to understand that number. I really can't figure out how the number could have been anything like, at any one time, $7.7 trillion. That's basically the entire right side of the balance sheet of the entire U.S. banking system. That is not to say that the number was not large; it was huge, whatever it was.
But after all, the essential feature of central banking, ever since the Bank of England was created, is that the central bank is supposed to provide short-term liquidity when the markets freeze up. This is exactly what the Reserve Bank was supposed to be. These loans have to be well-secured.
So the government was never at risk, or at de minimis risk, on these loans. There's a whole protocol for this type of lending. And there was deep concern, and I think legitimate concern, that unless the banks were liquid, they would just stop lending.
There wasn't an increase in lending, but what you don't know is how much of a decline in lending. Without the liquidity, there would have been no prospect of continuing to lend, which would further have exacerbated the crisis.
This is an area where I think it's easy to criticize, but I think when you understand what is the role of the central bank, they did what they were supposed to do.
But do you understand the anger that was out there from Congress and such, that they were not told the extensive nature of the amount of money that was flowing?
... Congress had the chance to debate this very issue in Dodd-Frank [Wall Street Reform and Consumer Protection Act], and what they decided was that it would be too dangerous, too risky to confidence in the marketplace for there to be immediate disclosure. So there's a one-year time lag.
From now on, this will be disclosed. This issue was fully debated in Congress, and that was the decision. So for certain Congressmen/women to say that we're terribly distraught about all this undercuts the exact bill that they approved.
There is understandable anger about the whole crisis, but this is one which I think has been blown out of proportion.
Let's go to TARP [Troubled Asset Relief Program]. So Paulson and Bernanke, ... did they accurately define it to those in Washington in power, to those in Congress? Did they oversell it any? ...
I do not believe that Secretary Paulson and Chairman Bernanke oversold TARP. We were on the edge of an abyss, and it took something extremely dramatic to try and pull us back. It may have been the case that it could have been sold better. …
The forebear of TARP is a program in the '30s called the Reconstruction Finance Corporation, which put billions of dollars of preferred stock into the banking system and was, by all accounts, a highly successful program. I wish they would have gone back to that program and said: Look how well it worked; we're doing the same thing here.
I think the other failure in TARP was not that they went to direct capital injections, which made all the sense in the world, but that they didn't take maybe $200 billion of that $750 billion and put it directly to work in the housing markets, which could have helped a lot.
Because housing is the single most important factor in our economy. The housing market was a true disaster, and it could have been used to try and stabilize housing prices. That could have made a major difference going forward. ...
This is during the campaign. Did the politicians seem to understand the ramifications of what was really going on here? ...
I think for the most part, unlike a lot of what is going on today, that the leading members on both sides of the aisle acted responsibly in recognizing that they needed to act promptly and adopt the TARP legislation, which most understood was not going to be popular. But sometimes you have to rise above that, and that's why I call their actions responsible. ...
How scared on Wall Street were people that there was a completely new administration coming in?
There was a general view that the president-elect was a very smart person and was looked upon really as a source of hope. I think that some of the early nominations that he made were also comforting to Wall Street, such as Tim Geithner. I don't think that Wall Street at all looked upon the new administration coming in as a major threat.
Around [Sen. Obama] during the election were a lot of progressive economists. But then he picks Geithner and [Larry] Summers and holds on to Bernanke. Was that surprising? Explain how it was viewed by Wall Street.
I think that Wall Street viewed Geithner, Bernanke, Summers as a commitment by the incoming administration to balance a centrist view, not leaning way to the left. There were some of the economists -- they don't like to be reminded about it now -- who were strongly urging that the whole banking system be nationalized. That was a view which was I think short-sighted, but it was certainly loudly articulated. ...
Why do you think Geithner got the nod?
I think Geithner got the nod because of his superb performance during the crisis. ...
How different is this new administration and the policies that they're following? ...
... I would say the new administration has significant differences from the prior administration. ... The deregulatory ethos really which had existed for the prior nine or 10 years -- the new administration I think clearly sees the need for an enhanced regulatory system. ...
... What's your point of view about Greenspan coming back and apologizing for getting it wrong about deregulation?
... I admire anybody who can admit mistakes, because that's a fairly rare quality. And in retrospect certainly, I think they did get it wrong by letting it go too far.
There was a lot of regulation which made no sense, and therefore cleaning that out was the right thing to do, but I don't think you can have a financial system or economy like we have without any regulation. ...
... Obama and Geithner's plans didn't break up the megabanks, even the banks that were in real trouble like [Citibank]. Why do you think they went that direction? ...
I think there was some concern that a more radical approach to the banking system could have been taken, and that the breaking up the banks would have been the meat-ax approach as opposed to the scalpel.
In my view, that would have been a mistake. ... You don't try and regulate a financial system with a meat-ax; you do use a scalpel, you do change the regulation. You just don't say that banks are too big and break them up. ...
In fact, in large part due to Geithner but also to some key senators, we now deal with this a much more effective way, through a resolution scheme which lets a big bank fail. So we really have a situation where too big to fail, I believe, has been eliminated, or very close to it.
People say nobody knows how the resolution authority works either, especially because all banks are international at this point, and who knows if you try to do something here in the States how that would affect a percentage of the bank that's in another country. In reality, do you think we are safer?
We are definitely safer for any number of reasons: because of this resolution regime, because of living wills, because of various new standards.
But you do point out the single biggest flaw in any resolution scheme, which is the largest banks have, depending on the institution, a substantial international aspect. ... You're never going to have a single resolution scheme globally, but what you need to do is to make them compatible.
There are actually some relatively simple steps that would solve 75, 80 percent of the problem, such as international agreement as to which law, whose resolution scheme governs. That's something which a number of people have been urging and I regard as at a very highest level of priority.
The bottom line on Dodd-Frank is can Washington actually regulate what Wall Street in the end does?
There is a concern that Wall Street will somehow always outflank the regulators. I'm not sure that history sustains that proposition.
When people look at the first part of this century, ... we were really talking about a whole deregulatory environment. So it wasn't that Wall Street could get around regulation; it was that Washington was pulling away from regulation.
In my view, with good regulation, good regulators, it will be extremely difficult for Wall Street to evade, but that has to be comprehensive regulation. We referred earlier to the shadow banking system. You can't have a big segment of the financial system outside of regulatory purview.
What you also need to do is to end a view which is incredibly penny-wise and pound-foolish, and that is to cut the budgets of these regulatory agencies. People don't go into that for the money, but they do need the staff and they do need the resources.
... Looking back at those years, why did we go in that direction so strongly that we put ourselves in this dangerous situation?
It's a terrific question as to why we went to this deregulatory mode. I think it was perhaps hubris that everything had gone so well, and it was a political philosophy for some people. But it was even then difficult to explain and now close to impossible to explain.
... Does Wall Street understand now the need for regulation?
The key leaders on Wall Street do understand the need for regulation, certainly for the right type of regulation, which has to be robust but also enlightened. Regulation for regulation's sake makes no sense.
Dodd-Frank, does it make sense? Will it change anything?
I've always thought that there was both a good Dodd-Frank and a bad Dodd-Frank.
The good Dodd-Frank was the administration's original proposal, which will change things in a number of ways. You will have better capital, better liquidity, better resolution opportunities, some of the systemic risk conductors will be eliminated, a more comprehensive regulatory overview, an office of financial research, many good aspects of Dodd-Frank.
The bad aspects were the add-ons. Whenever you get a piece of legislation like that, it becomes the inevitable Christmas tree to hang all the ornaments on, and there were a number of provisions which I think ultimately will prove to be detrimental. ...
Then in October, Citi is trying to rescue itself with a purchase of Wachovia. ...Your client was Wachovia. ... Describe what happened there.
What happened was Wachovia was in very serious shape. They lost their funding at the end of a week. We had round-the-clock marathon negotiations with both Citi and Wells [Fargo].
The end of the day, neither was prepared to do a transaction without government assistance, at which point it now becomes the government's issue. And very early Monday morning, the FDIC [Federal Deposit Insurance Corporation] said that Citi was the successful acquiror of Wachovia with the assistance package.
We then tried to negotiate for several days to finalize a deal with Citi, and just as we were getting very close, Wells came in with a much higher offer without government assistance. I was frankly surprised that various government agencies would permit this to happen.
So after [Wachovia President and CEO] Bob Steel and I discussed it, we divided the government agencies and made our phone calls to make sure that they had no objection to Wells, because the last thing we wanted to do was disrupt the Citi transaction and then find that Wells was not buyable. And every sounding was either positive or neutral.
What did you do next?
Next we called the board of Wachovia. We got on the phone with Wells counsel to say that we would be interested in pursuing it. It would have to be done very quickly.
They said: Guess what? We have a merger agreement and you won't have any problems with it. These were lawyers we know very well and are very skillful at deal making from Wachtell, Lipton. The agreement came over, it was true to their word, and it was very easy to sign. We got the board together and we said, "Here are the two options," and we decided to sign the Wells transaction.
When and how did you inform [Citigroup CEO] Vikram Pandit? How did he react?
Mr. Pandit was called within a few minutes afterwards. Bob Steel felt it was very important as just a matter of humanity that Mr. Pandit didn't wake up the next morning and read about it in the newspaper. ...
I think Vikram Pandit was shocked, as I certainly would have been receiving news like that. ... He was angry, and I don't think that is unjustifiable in his position. This was a transaction which would have made a lot of sense for Citi, and now it looked like it would be lost. ...
... This is just before the TARP money is paid out. How did those bankers with whom you were working and talking explain to you the rationale for all the risk they had taken, and how their risk teams had missed the problems?
... This was not all banks by any means. If you look at the major U.S. banks and other financial institutions, only some of them had taken excessive risks. And some of the bankers that did were then, and are still, in denial.
I remember one banker, whom I will not name, who called me after I had said something which was critical of the risk management at his institution, ... and he said: "You just don't understand what happened. How could anybody have anticipated that we would have this huge decline in the housing market?"
It's a natural human instinct not to be willing to admit mistakes, but I think those who are more truthful with themselves and more introspective are willing to acknowledge that when you're making a lot of money in a particular area, you just don't look as carefully as you should.
Good risk management would have been if you're making outsized profits, to look if there is an outsized risk, since the two usually go hand in hand. But instead, perhaps there was even less analysis of the risk involved.
There's the old adage that if it's too good to be true--
It is. ... They haven't uncovered the magic formula to spin straw into gold, so when you're making outsized profits, it is almost always the fact that you're just going out further on the risk curve. ...
The question of bonuses and compensation. This has a lot of people, rightly perhaps, very upset. How do bankers justify these bonuses in your view?
To some extent the bonuses are justified and can be justified if they reflect someone's contribution to the company.
The problem is with the incentive compensation schemes -- which I think the regulators have focused on like a laser beam in the last couple years -- which encourage immediate profitability without regard to longer-tail or even shorter-tail risk.
I would argue that the system was flawed in the sense of not tying compensation to risk and ... not having clawback provisions. ...
Do you think that a bank holding company the size of Citigroup could be taken apart?
It is far more difficult than people imagine.
You're on the FDIC's resolution committee.
... One of the efforts being made by the FDIC through the whole so-called living will process -- and hopefully our committee has some input into this -- would be to make it easier to take apart a major bank if it runs into very deep trouble.
The single-biggest flaw, in my view, which was exemplified by the 2008 crisis is there was no game plan. There was no break-the-glass-in-case-of-fire little pamphlet which said here's how we're going to do it. ...
Every decision was ad hoc, under extraordinary time pressure, and the best people in the world are going to make less than optimal decisions in those cases. ...
But are we safe if we can't figure out a way to take down a big bank if we remain with this "too big to fail" problem?
... We've got to end too big to fail, and the way to deal with that is to have multiple options and to have them analyzed in advance.
Personally I think the best way would probably be to go through a recapitalization arrangement. Go to the creditors and say, "If we will turn your debt into equity, will you come in?"
It will not be done as a living bank. The bank will be failed. The company will be failed. It will be taken into resolution. The bad parts will be left behind. The good parts will be available for recapitalization.
It gives the creditors the opportunity to take their chances on the bad bank, or to turn their interest into equity in the good bank. And you would go what I would call a stack, so subordinated debt comes first, long-term debt second, and that will almost certainly be enough.
There could also be the option of bringing in private equity, new forms of capital for this institution.
You have to have the option of selling pieces, but all of this all these options need to be available and thought through ahead of time. This is a critical problem, and it's critical I think for reasons not fully understood. ...
Why is untenable to treat them like utilities, require double the kind of capital requirements that are now going to be in place?
... The difference is utilities are almost all monopolies, and utilities also are not in the risk-taking business.
Banks are in the risk-taking business; that's what banking is all about. Banks take at least three major types of risk. They take credit risk. If they're not willing to take credit risk, we don't have a well-functioning economy. They take counterparty risk, as money has to move from party to party. And they take what I would call asset liability risk, because most funders are short and most uses of capital are long, so banks have to bridge that.
There's a difference, obviously, between excessive, undue risk on one hand, and appropriate risk on the other. But one argument that I always use when this question comes up is would you want a bank never to have a bad loan? I would say if you have such a bank, that bank would not be making a lot of good loans. ...
What was your opinion of the stress tests? Were you consulted?
I was not consulted. I was dubious when they were initiated, and I think this was as fine an accomplishment as the Treasury Department and the other agencies had. ...
[Why were] you were dubious about the stress tests?
I was very concerned that the announcements of the results would lead to even more pressure and even bank failures, but it was very carefully calibrated and handled by the government. I'm talking about the 2009 stress test, because there have been one set since then, and one just announced. But it was very thoughtfully done, very carefully done, and it worked out superbly. ...
... There are various hearings that took place in 2010 on [Capitol] Hill. Many bankers were brought in and read the riot act. How has Wall Street reacted to that?
I think Wall Street reacted with a mixture of both shock that they are seen as such villains, but in a number of the senior bankers who really think this through, after the initial shock wears off, begin to understand what the causes of the indignation, the outrage are. ...
People are angry at the whole financial system. They call it Wall Street, and they hold Wall Street responsible for engaging in risky trading, in building up lots of leverage, and then taking us all down.
They do. It's a widespread view.
It's not accurate?
I don't believe that the major banks can be held solely responsible for what happened. They played a role. So did housing policy in this country, which made no sense. So did various governmental policies, which in retrospect at least were ill-thought-through.
You don't wind up with a crisis of this magnitude because of one subset of the economy. There had to be many contributing pieces. ...
We went from 1933 until 2008 without a cataclysmic meltdown like we witnessed and went through. The argument is that somehow we had been protected by the Glass-Steagall [Act]. You reject that idea.
I do reject that idea. Let's look at the timing. By the early 1990s, the Federal Reserve had already permitted banks to engage in significant securities activities. By 1997, the last barriers to security activities had been removed. And it seems like if that was the cause, it took an awful long time.
... I really don't think that the removal of those barriers had much to do with the problem. ...
... But isn't it true that ... taking away the regulation since the 1970s, through the Reagan era, all the way up to the repeal of the last vestiges of Glass-Steagall created a culture of risk-taking that we need to get away from?
I think we need always to control risk, to regulate risk. But we also had 750 banks, roughly, fail, which were medium-sized and small banks that had nothing to do with securities activities. They took risk, but risk of a different sort. ...
The question to me is not trying to get risk entirely out of the system, because then you have an unproductive financial system, but it's managing and controlling risk. ...
We still have a largely unregulated shadow banking system where great amounts of trading and speculative behavior can go on. Why?
The Dodd-Frank has many good features, and one of them is to lay the groundwork for controlling the shadow banking system. That has not been effectuated as quickly as other rule-making aspects.
Hopefully they will move. There's not as much urgency because the shadow banking system today is constrained by the lack of funding, but sooner or later those disciplines will disappear. ...
Again, no single group of entity bears all the blame, but the real virus of the housing problem was not in the commercial banks; it was in all the mortgage banks and brokers which were basically unregulated, the true exemplars of the shadow banking system.
Many of them are still relatively unregulated.
Most of them are gone because they failed. But the remainder are unregulated. ...
Why are bankers not lending money? ... The Treasury Department said, at least publicly, that [the TARP] money was then going to go through the system and banks would start lending money again. They paid bonuses at the end of the year. They sat on a lot of money. What they didn't do was lend money. ...
It's always difficult to tell whether TARP actually failed in the sense that you are discussing, because of what we don't know. It's the road not traveled. What we don't know is whether there would have been even more deleveraging and less lending without TARP.
You're speaking Obama's language now.
If that is what he's saying, then I guess I'm in good company. I do not fault TARP on that ground.
I think the problem is what you have already identified. There is so much concern about risk that banks simply aren't taking the risks that they would have just a few years ago. ... There is really a different lending culture, which isn't necessarily all bad. ...
Give me some sense of how these meetings are going at the FDIC that you participate in to resolve these and other issues?
There's only been one. There's a big push on transparency. It's all Web-cast. I think the very first meeting, there was a lot of give-and-take. A number of very capable people there. It is absolutely clear to me the FDIC is taking this very seriously, and they are continuously searching for the best process to build up an effective resolution system.
Certainly, [former FDIC Chair] Sheila Bair made a major effort. The current general counsel, Mike Krimminger, goes all over the world to work on this. The acting chair, Marty Gruenberg, is, I think, deeply committed to this. ...
What kind of work are you doing vis-à-vis Europe?
Actually relatively little. The Europeans are figuring it out for themselves. ...
They're taking in Treasury Department officials on the planes back and forth a lot.
There is consultation with Treasury. How much they're really listening to Treasury, I don't know. But we certainly are advising clients elsewhere in the world as to potential ramifications of what is going on in Europe. …
So is this batten down the hatches, pull down the sails, ride out the storm? What are you telling them?
What we are trying to tell them is that we have to have as many lines of communication open as possible and to be as innovative as possible. Because the idea of a fortress America, if you go back in history, that's sort of the position the United States took after the First World War economically as well as politically and militarily. And the economic pullback from the rest of the world, whether it was the Smoot-Hawley Tariff or whatever, was equally damaging as the political withdrawal.
So anybody who thinks that we're going to be able to withstand with minimal damage a collapsing Europe, I think, is taking an enormous risk. ...
How has President Obama played on Wall Street?
Clearly there is a lot of unhappiness on Wall Street with the president. I probably am a fairly small minority, but I would disagree with the view.
... Why is the president unpopular on Wall Street?
... In part it's because of some of the rhetoric, some of the attacks on banks.
He called the bonuses shameful.
... I think you have to understand that politics are politics, and words like that will be used. ... There inevitably have to be times where he says things which are helpful politically, even if they are harmful to the other side. ...
But if you look at what he has done and what he has not done, that's where I am. I find him much more supportive of the financial system than I think he is given credit for. ...
Running through the public discussion on all of this is this sense of what social good are these banks providing?
... Without credit, you don't have new businesses, you don't have business expansion, you don't have job growth. And proprietary trading, which one can argue about at a different level, is a tiny part of even the major financial institutions.
But collectively, if you take all the hedge funds and all the proprietary trading at the investment banks and the commercial banks, you've got a fairly large industry that didn't exist several decades ago. What good is it?
At least part of the good is that they provide a lot more liquidity to the marketplace. Think about a small start-up company that is going out and offering its stock for the first time. And think about two separate hypotheses: The first is that there is no liquid aftermarket, and the second is that there is a liquid aftermarket maintained by investment banks, maintained by hedge funds. That company will be able to get a lot more money in its initial offering if investors know that there is a market into which they can sell. ...
Are we better off now having gone through this crisis? ... Is our banking system any safer?
Our banking system is far safer today than it was before. Capital is double what it was. Asset quality is better. Liquidity is much better. And there is much closer supervision and limits on risk-taking.
There is the huge problem outside the banking system, and that is particularly the housing market, where we really need a concerted effort, much more expansive than what we've done today. ...
Banks are healthier. Banks have higher capital levels. Banks have more liquidity. When do the benefits show up in the economy?
The one thing banks don't have is higher earnings, so it's going to take time for those earnings to start to improve. I think until then, it's going to be difficult for the banks to deal with the greater economic issues.
But there are ways. It's been widely reported about mortgage settlement negotiations with respect to servicing. This could put billions and billions of dollars into relief for homeowners.
I can't think of anything which would represent a nicer holiday present than getting that settlement wrapped up before year-end. Tens of thousands of homeowners would benefit if this can go into play. ...
We've just come through another year and seen bonus pools up, lots of compensation for bankers. People are bitter. They're not seeing any results on Main Street, but yet the bankers seem to be doing just fine and making huge bonuses. And those bonuses don't do anything to quell the risky behavior of the past.
... The major point is that in large part due to the banking agencies, but also due in some part to self-discipline, these bonuses now are much more closely tied to risk, and in particular clawback arrangements, whereby if it turns out that the bonuses were earned and the work turns out after a year or two or three, to have been less profitable or actually incurred losses, there can be clawbacks of the bonuses.
There is much more attention being paid to the relationship between the risk incurred and the size of the bonus. I'm sure it is far from perfect, but I think there are major efforts being made.
Why not have a compensation system that gets rid of bonuses and just ties people's income to their performance?
The irony here is that's the way it largely used to be, and Congress in its infinite wisdom decided that if you did it that way, it would be subject to a much higher tax level. That really is what led to the bonus system being a far greater component of total compensation. ...
"The FRONTLINE Interviews" tell the story of history in the making. Produced in collaboration with Duke University's Rutherfurd Living History Program. Learn more...