Why would a big bank with so much at stake not care about the risks that they were taking?
Well, at that point, they'd all been bailed out. I mean, my feeling at that point was, well, of course they don't care, because they're government-backed. They just simply don't care. And that brings us to this "too big to fail" problem.
I mean, we have to make it a situation where banks actually, like hedge funds, care about losing money. And, you know, it's strange to say that we want to make banks more like hedge funds, because I don't really want to make banks more like hedge funds in a larger sense, but I do want them to care. I want there to be people who take responsibility for those things. That's another thing is I feel like, you know, in a larger sense, the people at the risk groups -- and this is true not just at banks; it's also been true at hedge funds -- people in the risk groups are kind of second-class citizens within Wall Street.
And often the people in charge of risk are not given enough power to actually implement. Even if they see risky trends going on that shouldn't be going on, they're not given enough power to actually stop them. I mean, great example -- in fact, a recent example -- is the chief risk officer from MF Global who was, you know, warned about [CEO Jon] Corzine's big bet on Italian bonds, and he was ignored and left. And I'm not sure if he was fired or he just resigned.
But he clearly was being ignored. And that's standard issue for risk officers. And there's lots of examples of that that were going on during the credit crisis. What's sad about MF Global is that they're still going on right now.
They're not just bankrupt. They've lost money; they've lost track of money that was their customers' money, not investors'. Investors know going in that they might lose money, and those investors certainly have lost money.
What we're talking about is the customers of this -- it's in a futures exchange, so the customers are farmers who, like, are trying to hedge their crops, and they put money in these accounts that are not supposed to be touched but somehow were not only touched but ransacked. And nobody knows where the money -- it's been two months; nobody knows where the money is.
Somebody knows where the money is.
Yeah. Nobody's saying where the money is. And the farmers have recently sued MF Global. And, you know, it's something to keep an eye on. It's really quite amazing that this kind of thing is still happening.
Moral hazard. And what the FDIC did by bailing out everyone kept increasing moral hazard. Big mistake. What should happen in any bank failure is that everybody except the insured depositor takes a haircut to solve the problem between the liquidation of the bank and what the net worth is. Whatever issue remains between the value of the assets, the liabilities should be distributed among the investors, all taking a haircut, so that the FDIC fund, and certainly even the taxpayer, doesn't have to pay a dime.
And if we were to start doing that, and if we had done it years ago, I don't think we would have the failures today, because there would be a lot more market discipline.
So that's why the failures were in the investment banks that were more focused on a narrow line of business?
Yes. But you can go back, again, before interstate banking, and I don't know if you remember, but Texas banks all failed in the late '80s, early '90s. They, before their failure, the Texas banks were considered to be some of the most successful banks in the entire United States. But because they were confined to Texas, they were basically confined to commercial real estate, because Texas was booming at that time because of energy, because of the embargo. And when both the commercial real estate and the energy industries collapsed, then the Texas economy collapsed, and all the big Texas banks failed.
You remember the S&L crisis. And there's no single S&L that was that big, but they were all in commercial and residential real estate. And when that hit nationally as a problem, remember, we had to spend $150 billion to bail out the S&Ls. They weren't big.
So there's many examples of relatively small institutions that have failed in this. Even in this crisis, the originators of mortgages, there was two big originators. There was Washington Mutual and Countrywide. The rest were all very small. There was IndyMac, New Century Financial, First Franklin, WMC Mortgage, Option One, Fremont. You didn't even hear of those names. All relatively small, but they were the very significant portion of the subprime exotic mortgages that were originated. And they all failed, and they caused the problem more than any of the big institutions in terms of origination. Now, their brethren, the investment banks, were the ones who distributed that.
So I think there's lots of evidence that there is no general relationship between bank failure[s].
The second issue relative to too big to fail, however, is that I think the FDIC [Federal Deposit Insurance Corp.], which is the agency that handles bank failures, insured bank failures, had made a great mistake in the past. They had basically bailed out everybody, not just insured depositors, when a bank fails, and I think therefore there was very little due diligence being done by other investors because they were always bailed out before. I think that's a huge mistake. We have to get to market discipline.
You're watching all [the Troubled Asset Relief Program negotiations] from the sidelines?
Pretty much. We were not really involved in their first attempt to get TARP passed. We got brought in later because they couldn't get the votes, and so one of the things they decided to do to get the votes was to increase the deposit insurance limit to $250,000. ...
So you had to agree to that?
Right. We had to buy in. They needed us to get the votes, so we got brought in at that point.
And that was throwing something out to Main Street?
That was the Main Street benefit. ...
I was summoned to a meeting. ... It was at Hank Paulson's office. I kept asking him what it was about. Nobody would tell me what it was about. I thought it was about TARP and how to spend the TARP money. ...
I go into the room, and there's Hank sitting there, Ben [Bernanke] sitting there, and Tim Geithner's on the phone. And they basically hand me a piece of paper that would have the FDIC announcing that they're going to guarantee pretty much all of the liabilities in the financial sector. So all the debt we're going to guarantee for banks and bank holding companies.
That was quite a thing, and I didn't want to do that. ... So I told them that I would have to think about that.
On the one hand, it's hard for the chairman of the FDIC to go in a meeting and be pointedly asked by the secretary of the Treasury and the chairman of the Fed to do something and to say no. But I bought for time. I played for time. ...
Was that a tense meeting?
I don't know if it was tense. I was so flabbergasted. At that point I didn't even have the wherewithal to fight back. I just played for time. I said, "I have to go talk to my board about it." ...
So anyway, I went back, talked to the board, my internal directors. They had the same reaction I did. They were incredulous.
What is that they're asking you to do?
... I didn't bring the text with me, but it basically said the FDIC would guarantee all the creditors of banks and bank holding companies, including the investment banks.
So they want your budget?
They want my budget. They wanted my legal authority ... to guarantee debt, guarantee bondholders. It's all about the bondholders.
Where was that money going to come from?
... That what was one of my questions.
One of the criticisms I got during the crisis was that all I cared about was the FDIC, and I didn't care about broader financial stability.
Well the FDIC was holding things together. … If people had lost confidence in the FDIC and started pulling their money out of banks, we would have been back in the Stone Ages. It would have been cataclysmic. I don't even want to think about what would have happened.
So this idea that by caring about the FDIC I wasn't caring about system stability I thought was ludicrous. I was very concerned about the credibility of the FDIC doing what it was supposed to do, which was insure deposits.
Now if I go out and insure all the debt and $13 trillion financial system, what kind of credibility was I going to have? Insured depositors are going to be saying, "They can't do all that."
So I told them that, and that was one of the many arguments I used subsequently to tell them we weren't going to do that. ...
So you're insuring, at the FDIC, Main Street?
But you're being asked by these three guys to insure Wall Street?
Pretty much. To insure the bondholders, and these are big Wall Street firms, pension funds, big bondholders, mutual funds.
Which props up Wall Street, but this is not your mandate?
... It's not anywhere close to our mandate. It was a real stretch in terms of legal authority, and it was a huge stretch in terms of our financial capability to make good on this. ...
So did you say no?
... We entered into a negotiation. Throughout the crisis ... another criticism was that I wasn't a team player, I was always difficult. I tried very hard to meet these folks halfway, even though I didn't agree with a lot of what was going on. ...
The markets were freezing up. Nobody wanted to lend to anybody after the Lehman failure, and I agreed there was a problem with the ability of financial institutions to roll expiring debt. ...
So ... we said we'll guarantee new debt. We will not guarantee the existing debt. That's there for loss absorption if these institutions go down. And then we're also going to charge money for it."
You wanted some moral hazard?
Yeah. Actually our original proposal was we'd only guarantee 90 percent of it. We wanted them to take 10 percent, and that was just a non-starter with both the Fed and the Treasury. They said that wouldn't work. They just refused. ...
So you signed?
We did. I think at the peak of the program it was about $330 billion worth of debt. Have not taken any losses on it so far. I don't think we will. And we did make money off of it.
I don't think that justifies that. There's so much of this, "Oh, we made money off of the bailout." I'm not sure overall we did make money off the bailouts because you have to look at Fannie and Freddie and AIG and GM and some of the other places where the government's still in pretty deep.
We also printed a lot of money, which could come back to bite us.
That’s true. This could have tremendous inflationary pressures down the road. ...
... You feel that Lehman was mishandled. ... Should they not have let it fail? What else could have been done in that situation?
The issue of what to do with banks, financial institutions that owe more money than they can repay is obviously a vexing one, and we're supposed to prevent the problem occurring by having tight regulation, by close supervision. ...
When those two things that are supposed to protect us fail, in most democratic societies when you have large institutions what you do is you have to save the institution. But that doesn't mean that you save bondholders and you save shareholders. ...
The preservation of the institution is important, but not of those shareholders and bondholders. They didn't do their job of managing, monitoring, and they have to pay the price. They get the returns when things are well, and they have to pay the price when things go badly.
That's what we should have done in the case of Lehman Brothers, especially given that we didn't know what would happen if it fully failed. In that cloud of uncertainty, if the supervisors had done their job and our regulators had done their job and we knew the consequences, then you might say maybe we can have an orderly failure. But they didn't know, and that was irresponsible. ...
That was the fundamental mistake that was made by both Bush and Obama. They repeatedly saved the shareholders and the bondholders, and that's what causes moral hazard. Not only did we save the shareholders and the bondholders, we also saved the bankers. Many of these people still got their bonuses.
That's where there's such anger on the part of the American people, because they see their taxpayer money in effect protecting bonuses while they face the problem of unemployment and losing their home.
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.
[When Lehman was in trouble, Treasury Secretary Henry Paulson was concerned about moral hazard. What did you think?]
… The issue of moral hazard is an ongoing issue, and you never want to give people an artificial sense of security when they are not deserving of security. …
Is that what we did?
Well, again, you had to act under the circumstances at the time. What my concern is now is making sure that we don't provide this going forward. And you have to differentiate, as I said earlier, between tactics in battle and a broader strategy. And the key is to make sure the strategy long-term is such that we don't put ourselves in a position like this again.
We had gone through 25 years of tranquility, relatively speaking, and people got lazy, people got lax. And I do believe, incidentally, that the supervisory powers, including at the Federal Reserve, you know, sort of were lulled into sleep by the stability that we had enjoyed for so long. Trust me, we are not sleeping but fitfully, presently, and we will be on guard going forward.
At the time, Citibank and Bank of America were considered adequately capitalized under the regulatory standards. Winston Churchill had a great term: "terminological inexactitude." We have to be very, very careful. We've gone through several iterations of what the proper capital standards are. The Fed's working extremely hard at the Board of Governors, presently under the leadership of one of the governors, Daniel Tarullo, to make sure that we are very tough on new capital standards, we put them through stress tests and so on, and making sure that there is no longer the risk of terminological inexactitude. …
... Overall, how do you rate the decisions by the administration, by Geithner's Treasury Department and Bernanke's Fed?
If you judge the bailout by the fact that the banking system has survived, most of it, and that it's back paying bonuses, then you'd say it was a success.
If you judge the bailout on the criteria of has the banking system returned to lending, has the American economy been returned to health, has the problem of "too big to fail" banks been resolved, has the problem of non-transparency been resolved, you have to say we failed.
If you ask the question is the problem of moral hazard worse, you have to say we failed even more. Has the problem of the undermining of our democratic processes [been rescued]? You have to say we failed. ...
You're not worried about systemic risk when the ripples from the large bank failure with lots of haircuts from lots of investors occurs?
Well, I think it is a risk. But I think there's a greater risk, that if you don't start this process -- what you should do, at least in my opinion, is that you don't bail out anybody. Systemic risk occurs after two or three of the liquidations. Then you might have to do something. But again, there was a lot of people concerned that when Continental Bank failed, oh, we're going to have -- the interconnectedness is going to be a big problem. It worked out.
Drexel Burnham failed. We got through that...
We're going to have crises; we've had them forever. We had [them] with the robber barons. We had them during the Michael Milken days and insider trading. We had it with the Internet and the equity crisis. And they can lead to what I would call minor recessions that you have problems with.
But they're worked out. They don't become as massive as this one did. And I think that what happened here is, in the effort to bail everybody out, we not only didn't solve this problem, I think we made it worse. But even more problematic is you're setting it up for even a bigger problem next time, because of moral hazard and everyone believes that everyone's going to get bailed out.
You've got to bite the bullet.
So the role of moral hazard, how did that come into play?
I think when that was said, it was a bit of a surreal moment for everyone. Now, all of a sudden, we are all working together. My guess, the last time I recall working together with the group was Long-Term Capital [Management], which I knew the group well, one, because I was from Salomon Brothers, but also UBS was one of the big equity holders in Long-Term Capital. But since then there's been very few opportunities where the group -- on a positive note -- very few opportunities where the group has come together to say, "OK, we have to work in a crisis mode together and do what's best for the industry and the country."
And we started. We would get some information on Lehman, the balance sheet, their risks. And then there were a few possible bids at that point, which made us realize that we have a lot of work to do, because I think one bid was like, "I'll pay --" and these were soft bids, but -- "I'll pay a billion or $3 billion, but I won't take $70 billion of their assets." So then, all of a sudden, "OK, well, if we have that bid, how do we fund the $70 billion gap?" And the $70 billion was Lehman had $40 billion of commercial real estate; they had I think $20 billion of nonconforming mortgages and about $10 billion of private equity. I'm roughing it, but that's kind of where you got the $70 billion.
And then there was another bid that came in maybe a day later that, "I'll pay $3 billion and won't take $50 billion of assets." So at the end of the day, [what] we needed to figure out from a group is if there's a bid and there's a gap, how do we engage in filling that gap? Is there something we could or couldn't do? And we were working together on ideas with the regulators in the room, with the regulators outside the room.
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