The Fed and Treasury were approving enormous amounts of money that was flowing into these banks, banks that, by the way, at the same point were saying, "Hey, we're healthy; we don't even need the TARP money." TARP money is nothing compared to these low-interest-rate loans that they were getting. What are your thoughts about why that was felt it needed to be done, and why it needed to be done basically in secret?
So I think the important thing is the Federal Reserve in the fall of 2008 was basically the institution that was holding the financial system together and, because it's so important, holding the American economy together. And you will get no criticism from me about what [Chairman] Ben Bernanke and the Federal Reserve did in that period. When he was named Time's Man of the Year in 2009, I was in the car clapping, because I firmly believe that he played a crucial role in taking -- all of the initial shocks, the decline in the value of houses, the crash of the stock market, all of those things we were at least as bad as we were at the start of the Great Depression. And the reason we did not go to the kinds of horrible depth that we went in the 1930s is I think in large part because the Federal Reserve took incredibly extraordinary actions.
So I think that's the important part. And the way you deal with a system that's in the middle of a financial panic is to flood it with liquidity. It's what you teach your students, that if everybody decides that they're nervous and is trying to get their cash out of the system, that's exactly when -- even a perfectly healthy bank, right, that has its loans out and things, if everybody comes at once and says, "We want our cash," they say, "Wow, I've got to liquidate some of these very long-term assets that I have at fire-sale prices; I'm going to be insolvent."
And that's exactly the situation where you -- it's why you set up a central bank, so that in that situation, somebody can say: "You don't have to do that. We're going to get you the liquidity you need to deal with your depositors that are getting nervous." So that's the appropriate thing to do. And they were doing it.
In terms of why you do it in secret is precisely because -- we actually had some experience of this in the 1930s, that if you announce "This bank just got a really big loan," their depositors say, "Ooh, I guess they really are in trouble," and they start to run on that bank, so that in fact, there's a legitimate reason for not making that information available immediately when it's going on.
Our film starts as Bear Stearns is stumbling, and a rumor is going, and the housing bubble has burst, and it's all going to go down in about a week. From Dallas you must have watched some of this happen. What did you think about the idea of pumping that $30 billion into Bear Stearns? …
Well, first of all Tim Geithner then is head of the Federal Reserve Bank in New York, and he was on the front line. The way Ben Bernanke has chaired the Federal Reserve is all of us are consulted in the process. … We had countless video telephone conferences and other conferences, as well as meetings, to go over what was happening.
We did not supervise Bear Stearns. We did not have supervisory power over Lehman Brothers. We did not have supervisory power over AIG. But the role of a central bank in a crisis, in a panic -- and this goes back to the panic of 1825 and basically the handbook that was written by a man named [Walter] Bagehot with the Bank of England -- we, in essence, pulled out that playbook in a modern context, and we opened the floodgates. We were the lender of last resort. That's what a central bank does.
I take no issue with that urgent need for what we called "exigent action." The real thing is to prevent it from ... happening again. And one thing that Dodd-Frank does do is it puts these other kinds of large institutions under a body of supervision. There is an oversight committee. It is now chaired by the secretary of the Treasury. The chairman of the Federal Reserve is involved in all of the other agencies.
But at the time, it was seemingly just an extraordinary failure, or potential failure of the system that could bring the system down. And then there were others that follow, as you know, in consequence.
You felt that way, though? You really felt like when those phone calls and those video conferences were happening, you were at the edge of the abyss?
Well, you could see -- and this is the parlance of our business -- but you could see the credit default swap spreads widening. What that means is that the cost of insurance against risk was becoming more expensive and more expensive, and the market was telling you that something was wrong. And so it's one thing, when you're in a battle, you react tactically.
In terms of developing a strategy, being prepared for this, remember we had gone through almost 25 years of what they call the Great Moderation. Interest rates were low; we had new people coming into the competitive system, new populations like China bringing prices down, and very little volatility in the marketplace, with some exception of 1987, but they didn't last for very long. And I thing people became complacent. And with complacency, people take greater risk.
Again I want to remind you, Bear Stearns was not on our supervisory duty, but we had the job of stepping in to make sure that a panic didn't ensue that would end up compressing the entire global economy and leading to deflation. …
Talk about being on the hot seat.
I do believe the Fed not only did the right thing under the circumstances at the time. I want to remind your viewers, we did something that is very unusual in the government of the United States or any government anywhere in the world. We did what we said we would do, because the system stopped. All forms of payment froze when we got to the depth of the panic. Banks wouldn't lend money to each other.
The first money market mutual fund in the United States quote "broke the buck." Commercial paper, one of the most basic instruments in finance, that market failed. Someone had to step in and remake those markets, and we did it.
That's point number one. We actually did what we said we were going to do. Secondly, they worked. Thirdly, we made money for the United States taxpayer. And this is the most unusual part of all: When we were done, we closed them all down.
I'm very proud to be part of a team that actually did something that's almost never done in government: (a) create something and then close it down, and (b) have it be profitable for the taxpayer. But I certainly don't want to ever be part of any team that ever has to go through this again. … This was incredible decision-making under incredible duress.
But, you know, you could argue almost any single case is exceptional and has to be acted on. It's sort of a perverse Lake Wobegon. All our children are exceptional and everything is exigent and has to be acted on, and it's unusual and unique. And this is one of the traps you fall into when you have these large institutions that you don't really understand, are poorly regulated, which Bear Stearns, and Lehman, and AIG were. …
When you have that kind of concentration where you don't understand really where the risks are -- they're gigantic in size, they have global scope -- that's where you have a huge risk of an error infecting the rest of the system, what they call "contagion" in finance. …
The new president comes in. … What was the state of play on inauguration day?
You had a system that was in the midst of crisis. We had an economy that was rapidly submerged in increasing amounts of debt. On top of that, we were in an economic recession. And regardless of whether he's a Democrat or Republican, he stepped right in the middle of it immediately.
And so I think the good thing that the Fed was allowed to do is what the central bank should do at the time. And again, it is a unique body with its capacity to do what it does. It has to be careful. Obviously we've ended up with a much-bloated balance sheet compared to what we had before the crisis.
Just to give you some numbers to put things in perspective: Before the crisis, what we call the "footings" of the central bank, that is the assets balance sheet, was about $800 billion. Now it's close to almost $3 trillion. Well, why is that? It's not because of the special programs we put together the patchwork to solve the insolvency of these various markets. Those worked, as I said before. They've been closed down. They made money for the taxpayer. They restored liquidity in the system.
The question really is what do we do in a postoperative sense? And this is now running into the last year of a first, or ultimate presidential administration for this president. We have kept rates very low. We've re-liquified the system. This is very, very important. We provide the gasoline for the engine of our economy. We have very full gas tanks right now. We have sitting on deposit at the 12 Federal Reserve Banks, where private banks put their excess reserves, almost $1.7 trillion in excess reserves, for which we pay them 25/100ths of 1 percent per annum. No banker wants to just sit with that. They'd like to make more money of it.
Corporate America, separate from that, we estimate has over $2 trillion in excess cash sitting on their balance sheets that they don't need under the current cash flow design and needs and their capital expansion necessities or plans. And then the non-depository financial institutions, the buyer groups and others, have copious amounts of cash.
So we've gone from what happened at the beginning of this presidency, which was no liquidity and a crisis, to now a re-liquified system. … Now we are flush with capital, and we're beginning to see it, but how do you accelerate the economy? How do you incentivize? And so it's a different set of problems now that this president came in with, or the last president had to confront at the end of his term.
... What you're saying in the case of credit default swaps is they were in an unregulated space, so nobody was checking [whether] the buyers or sellers of these things would be solvent in the event of a calamity?
Exactly, and was a real dereliction of responsibility of the Federal Reserve, particularly Federal Reserve in New York, which is where a lot of this was going on.
How do you account for the fact that a lot of smart people made this miscalculation?
I think it has to be self-interest. They were captured by the financial market.
And making a lot of money?
Those in the financial sector were making a lot of money.
The regulators don't make any more money.
The regulators were what we call "cognitively captured." They spent all the time with the bankers. The bankers said: There's a wonderful party going on. Don't spoil it. We're smart people. Trust us.
You see that mentality reflected so strongly in the testimony that Alan Greenspan gave to Congress where he said: "There was a flaw in my reasoning. I thought that the banks would manage their risk better, and obviously they didn't."
But I think actually that that position was untenable and irresponsible, because you don't, as a regulator, just trust. Your job is to make sure that if they don't do their job, the consequences for our banking system, for our whole economy, aren't a disaster. ...
You were talking to them during that period.
Well, yes. But I think the mistake that was made in terms of process was not talking more to people about what should be done and what are the ramifications if we do thus and so, and so on. And this culminated in the infamous October meeting when we were all called to Washington. And I believe the TARP [Troubled Asset Relief Program] decision of forcing people to take money they didn't want or didn't need was one of the worst economic decisions in the history of the United States.
Now, obviously, Hank was involved in that decision. My own intuition is that he was prodded to do that by others. Then he became convinced it was the right thing to do. But I don't think it was his idea or that he was the primary proponent of that process.
Who prompted him to do it?
I think regulators were the ones that were --
I think the Fed was probably number one.
Well, Geithner as head of the New York Fed. Most of this happened in New York. And New York Fed is a permanent member of the FOMC [Federal Open Market Committee] They're the operation that -- they do the transactions of issuing debt, Treasury debt and equity for the Fed and so on. So they're kind of the money market and capital markets engine for the Fed.
And I believe that they felt that the world was coming to an end and we had to save the world, and this was the way to save the world.
Do you think Geithner convinced Paulson?
I think a number of regulators, primarily the Fed, convinced Paulson that that's what they had -- remember, he came out with this toxic assets, they were going to use $700 billion for toxic assets.
And the second thing is --
... The Bloomberg article that came out a few weeks ago, about forget the TARP [Troubled Asset Relief Program], the reality is that there was $7.7 trillion that was lent or opened up to the banks in one way or another, low interest rate loans and everything else. Tell me what the conversation was, what the reaction of the administration was. ...
... Remember the bank bailout stretched out over a very long period of time. Data that's only become available more recently has revealed how deep the problems were.
The first clear symptom was the Bear Stearns bailout in March 2008. A lot of people were very worried after the breaking of the housing bubble. They were aware that banks had exposure. Many economists thought the likelihood that there would be severe consequences was very high.
[Federal Reserve Chairman Ben] Bernanke made a speech: Don't worry, the risks are contained. Those of us who listened to that really got even more worried, because it was clear that they didn't understand or that they were covering up.
The data that has come out since about lending in 2007 and '08 by the Fed shows that it was massive, that the financial system was going through tremors, and they must have known it. The Fed was lending not just to American banks but to banks all over the world, and in amounts that were really astonishing. ...
I'm going to jump ahead and jump all over the place just to make sure we cover everything. ... You're sort of renowned for seeing troubles maybe before some others saw them, or at least understanding it a bit more than others. I want you to talk a little bit about what you saw, why you sort of saw troubles coming ahead. And then there's the famous memo that you wrote to other folks at UBS [Investment Bank] after coming back from dropping your son off at camp that July. Talk a little bit about what you saw and what you wrote down in this memo, why you wrote that memo.
It's interesting. So for most of my career until '04 I was always in sales and trading on the fixed-income side, so I was really a trader almost my entire career, and then 2004 at UBS I became chief operating officer, and then I eventually became president in late '07 when we were going through the real tough times at the firm and on the Street. But in mid-07 I was at a few different risk meetings for the firm, and I haven't been that close to the risk for a few years, and our leverage was very high; leverage at other institutions [was] getting high; people were talking about these Level 3 assets that I really never heard that much about before, which is things that you can't price on your balance sheet.
And I kind of felt like, OK, since the days I was trading, our goal was to be a boutique on steroids, be very nimble, be quick, be large, and do what you do well, but don't be everything to everyone everywhere. And then the Wall Street firms started getting much bigger and became -- they were on 100 exchanges, and they were in 50-plus countries, and the big firms did it with balance sheet and leverage. And it kind of felt to me like we were getting to this situation where I felt that firms were overlevered. We had a great 10-year run with growth, and it just felt to me that I had this gut feeling like things were going too well.
And then all of a sudden you started to hear the housing market start creaking a little, and it felt like there was going to be a real game change on the street. And then at UBS we mark to market; we have different accounting than the other competitors. We don't use gap accounting; we use IFRS [International Financial Reporting Standards] accounting, and we were one of the first shops that were going to show a billion-dollar loss. Well, a billion-dollar loss in sales and trading is pretty big, and that's an understatement.
And then you felt like things started getting stale. Positions started getting stale; you started to see liquidity dry up a little. And at that point -- we're in a business about liquidity. That is really our lifeline, funding ourselves and liquidity, and once you start seeing liquidity dry up and once you start seeing losses starting to come in larger numbers than you've heard before, there was a little nervousness.
So really, my view was I felt like things were starting to slow up. Most people felt like growth was going fast. Everyone had a view that the Fed was going to continue to stay neutral or hike rates. And for me, I felt like I disagree. I think we're going to get in a slowdown. I kind of think you're going to see the Fed start turning the other way. We really didn't have inflation. And so I kind of had a different view, and that's kind of culminated to kind of what's become a fun story to talk about the day of his birthday.
... Was there concern over what the reaction of Congress would be if they understood the numbers, the trillions and trillions of dollars that were actually going out?
So how Congress would have reacted, I think it's hard to know. I think Congress tends to not be completely rational about the Federal Reserve. I think we set up a central bank -- basically every country in the world sets up a central bank precisely because in a financial crisis, you need a lender of last resort, someone that can provide that kind of liquidity. And it's the appropriate thing to do. It's why you set up a central bank.
But in the heat of the moment, I don't have complete confidence that Congress would have said, "Oh, I understand." There would probably have been some fallout. But I'm sure that's not what the Fed was thinking about. I think they were absolutely thinking of this idea that secrecy is important, precisely because you don't want people to be taking as a sign of a problem that a bank is getting a loan.
There's a lot of complaints that it's not strong enough. What are your thoughts on Dodd-Frank?
I think the way the legislation was written was, it brought every systemically important institution into that regulatory framework. But then the main way that it does make financial institutions safer is through capital requirements, and that was left to the Federal Reserve to decide what they should be. And the Federal Reserve is working with other central banks, because it's very important to have a consistent framework across the world, exactly so that our financial institutions aren't disadvantaged in world financial markets.
But I think the way that process is going is that capital requirements are going to be substantially higher, and it is going to make the system substantially safer. And I think probably the best evidence that it's going to do that is financial institutions are screaming like crazy, right? How much do you hear them saying, "Let's get rid of this; this is going to hurt our profits"? Well, sometimes you need to do that. They definitely were living too close to the edge before the crisis, and they were not secure enough and well capitalized enough to take the kind of losses that happened. So let's set them up so that they can do that.
A lot of people argue throughout this process there were opportunities to leverage power, to change the system somewhat, to make a system where the banks were not so much in control because they were so big and you had to deal with them. What were your concerns back then? What are your concerns now about that issue?
I think the main way that we wanted to deal with the long-run health of the banks and this question of "We never want to go through what we went through in the fall of 2008," the focus turned to financial regulatory reform. And that's a case where the administration was incredibly aggressive, and this very much wrote the giant report about "Here's what we're thinking about financial regulatory reform; here's our proposed plan for what should be in it"; that that was the right way to deal with the structural issues [of] too big to fail, and how do we make sure we don't have another crisis and all of that.
And I think that was incredibly important legislation. I think it was fundamentally good legislation. The decision that was made was not to say every bank has to be little, because there are certainly issues of international competitiveness. And you also want a very strong banking system, and you want it here in the United States. You don't want it to all go to the Cayman Islands or someplace where it isn't regulated.
So how do you get a financial system that works for the economy, that's safe, that doesn't ever need government bailouts again? And that's, I think, what the Dodd-Frank [Wall Street Reform and Consumer Protection Act] financial regulatory reform bill is designed to do. And the big way in which it does that is fundamentally with capital requirements. So it changes the regulatory structure. It makes sure that one person, the Federal Reserve, is watching all of those big financially important institutions, including things that hadn't been in the regulatory net, like the AIGs of the world are now in that net very firmly.
But it basically said the best way to make a financial system stable is to make them have a lot of skin in the game, so to have big capital requirements so that if there is a run, if there are losses, there's a lot of investor capital there to take the loss, that it's not immediately the government has to be in there. And I think that is the fundamental logic behind it, and I think it's good logic.
... Bloomberg made a big to-do a month ago when they reported that $7.7 trillion had been open to the banks and financial institutions through the Fed. Not that they were given that money, but over a period of time that amount of money flowed out. There's of course a lot of debate over the figures, but the bottom line that people eventually say is that trillions were certainly opened up and given at different points to different banks at different periods of time, all in secret. ... So put that into perspective for us.
What I was referring to a moment ago was essentially the TARP money, money that the Treasury controlled. The Congress appropriated $700 billion for the TARP program, most of which never got used.
From the time that President Obama took office, the money that we used from the TARP program didn't go into the big banks; it actually went into the smaller banks. It went into the other programs we've discussed, which were designed to open up the credit markets and to deal with the legacy asset problem. We allocated some of the money for housing programs and for the auto resolution, but not into the big banks. ...
The Fed was tremendously effective in what they do. I think Ben Bernanke and his team deserve a ton of credit for keeping us out of the second Great Depression, and I think it's unfortunate and unfair for people in hindsight to be attacking them.
This lending program was a very important component of what helped turn around the system. The figures I think were grossly distorted. If I lend you a dollar today for 24 hours, you repay it tomorrow, and I lend you another dollar, and you repay it, and I lend you another dollar. That's not $3; it's $1.
But if these loans were overnight loans, you're double, triple, quadruple counting. I don't know what the multiple is, but you're greatly exaggerating the numbers is the first thing.
The second thing is these were loans made against collateral. One of the Fed's roles is a lender of last resort, and they lent against good collateral; they didn't lose any money. They made a tremendous profit for the taxpayer.
I think I read a couple weeks ago they just sent a check to the Treasury Department for $74 billion, a lot of which was as a result of programs that they put in place to try and prevent the economy from going into the abyss. ...
The issue ... still remains that it was done behind closed doors. People didn't know the programs were that extensive and the number of loans that needed to keep on going out. What's your take on that?
I actually think the information was out there. I haven't gone back and looked at the website and things like that, but these programs I thought were public. The Fed's balance sheet is public, so the amount of loans that they have outstanding in any given time is freely available. ...
And there's a lot made about the lack of regulation for this sector. It was important to the banks that this sector not be regulated.
Well, I don't -- that's an interesting statement, because everything we did off the loan portfolio was done, certainly, with the knowledge of our regulator. There was no hiding what we were doing. And in fact, the regulator was certainly very well aware of what we were looking to do in the loan portfolio with the usage of credit derivatives, and it was one of the drivers of a change in the regulatory capital rules globally. So we were initially talking about Basel I or ball one, and then we moved to ball two almost -- really as a direct result of the discussions we were having about managing the capital in our loan portfolios.
So you were regulated as a bank by --
Absolutely. We were regulated by the Fed.
By the Fed, and the OCC [Office of the Comptroller of the Currency].
I think we were regulated by everybody -- (laughs) -- because I'm pretty sure that the activities we did, every regulator was involved with [these] activities. I think that's the case with the larger major dealers. Every regulator has a hand in some activity that they're doing. ...
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