Moral Hazard

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?

Right.

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. ...