You write in the report that we didn't build jobs; we didn't build wealth; we built a sand castle economy. Explain what you meant by a "sand castle economy" that we built and how this came to be.
Well, I think looking back on it, we're going to see that one of the great tragedies of the years leading up to the crisis, particularly from the late '90s on, is we had cheap capital available, which could have been deployed to build enterprises, to create wealth, to put people to work in this country. But what did we do instead? We created $13 trillion of mortgage securities, many of them defective, many based on loans that never should have been made, many based on loans that were fraudulent.
And in the end of the day, what did we have to show for it? No real wealth creation, but merely the use of capital for speculation and speculation only. In the end, this was not anything about an economy that was creating real value. It was about an economy of money making money all the way along the chain. And you just have to look at the whole mortgage securities industry itself. People were making money at each step in the link, taking money out of the system. And at the end of the day, when the tide came in, it washed [it] all out, and there was nothing left.
Then 2008 and the meltdown begins. Had you envisioned that this was going to bring down a couple of big investment banks?
We thought it was going to be bad.
You thought it was going to be bad when?
We thought it was going to be bad in 2006. ...
But did you imagine that these problems that you were seeing at the sort of ground level were going to infect Bear Stearns or other investment banks on Wall Street?
Yes, because of a different issue on capital. Another battle we were fighting with other regulators was on what was called the Basel II capital standards. Basically this was an international agreement to let banks, large financial institutions, pretty much decide for themselves what kind of capital they had to hold. ...
This is all about the banks juicing up their returns by taking out a lot of leverage so they can, with a little money down, get a lot of action?
That’s exactly right, can get a lot of big, big returns on equity. So we stopped Basel II for FDIC-insured banks. We successfully blocked it.
But the SEC [Securities and Exchange Commission] implemented it for securities firms. ... They were operating on very thin levels of leverage and they [had] high-risk balance sheets, so we were very aware that they were very thinly capitalized because of the Basel II debate. ...
You’re watching a meltdown begin. You're seeing all these homeowners in trouble. ... Then you're being told at the same time that your banks ought to be able to take out more loans in order to keep this machine going?
That's exactly right. It was crazy. Basel II was birthed during this so-called golden age of banking, when everybody got enamored with the idea of self-regulating, self-correcting markets. You didn't need regulation. Banks knew better than regulators how much leverage they should take on and what their risk was.
So it was delusional. But the golden age of banking was because of an asset bubble that popped. It wasn't a sustainable model.
... Nobody saw that there was a bubble building in housing except for a few people.
They didn't, and the irony was that the Fed … had regulatory tools at their disposal to reign it back. They could have set lending standards across the board for everybody. They didn't do that. …
Did you see this then playing out in the failure of major investment banks?
But did you ever go to the Treasury and say, "You guys are going to watch these banks that are over-leveraged melt down in a matter of a month or a year from now"?
No, we never had that kind of a pointed discussion. They were really more general discussions about Basel II and the kind of leverage that large financial institutions -- and this is going on in Europe too. …
We didn't regulate investment banks. It was the SEC's responsibility, and you're always doing this delicate dance in terms of encroaching on other people's jurisdiction. ...
Phil, let's start with the meltdown and the causes. What did you guys find to be the basic causes of the meltdown?
Well, at the heart of this crisis were really the twin factors of recklessness on Wall Street -- unbridled, reckless actions -- coupled with abject regulatory neglect in Washington, this brew of a private, financial sector run amok without the kind of guardians of the public interest on the watch, protecting our economy, protecting our financial system. And I think when you look at what happened, what's most striking is the extent to which this was an avoidable crisis.
You know, there has been a whole school of rhetoric coming out of this crisis that it was the perfect storm, that this could not have been anticipated, that there were such large forces that collided that no human being could have foreseen the magnitude of what happened to our financial system and to our country. But when you look at the facts, what you will see is you will see a building over 30 years of a deregulatory mind-set in which the belief became embedded in intellectual circles and the financial circles that the financial masters on Wall Street had learned to control risk, that there was an intersection of their interest in self-preservation with the protection of the public interest, and there was a real belief in the light hand of regulation.
But in the early 2000s you see the emergence of lots of warning signs, red flags, flashing red and yellow lights along the way: the unsustainable rise in housing prices; the reports of egregious and predatory lending practices that were cropping up all over this country, starting in places like Cleveland and then spreading to the "sand states" [Arizona, California, Florida and Nevada].
What you see is, as early as 2004, the FBI is warning about an epidemic of mortgage fraud that, if left unchecked, could leave us with losses as big as the savings and loan crisis. You see the growing risk being taken by the big financial houses on Wall Street. Take, for example, Goldman Sachs. In 1997, I think they make about 39 percent or so, or in the high 30s of their revenue comes from what they call principal and trading, principal investment and trading.
By 2007 that has risen to about 79 percent, essentially making money just by trading on the marketplace. And of course you had that small matter of the doubling of mortgage debt in this country and the creation of $13 trillion of mortgage securities. All of that occurred as regulators either turned a blind eye or didn't have a real sense of the risks that were embedded in this system that had grown in the last two to three decades.
You were close to some of the members of the economic team around Obama during the [2007-8] campaign. ... The housing bubble had basically burst already in 2007. What was the conversation within the campaign? ...
There were several problems going on simultaneously. ... One problem that no one could ignore was that we had gone into recession [in] December 2007, and unemployment was increasing. A question was, how deep would the downturn be? How [high] would the unemployment be? ...
What had precipitated the recession was the breaking of the housing bubble. ... In the years preceding the breaking of the housing bubble, a disproportionate source of growth in the United States was related to the real estate sector. Forty percent of all investments were in real estate.
But even more, Americans were using their house as a piggybank. In one year alone, almost $1 trillion was taken out in what were called mortgage equity withdrawals, and that was sustaining consumption. Savings rate had gone down to zero. It was clearly unsustainable.
And if the American household couldn't consume at that level, if they went back to what you might call a more rational, normal level of savings -- going from zero to 5 percent GDP or something like that -- that would be an enormous deflationary pressure on the economy. The economy would be pulled back.
So the housing sector was critical both for the economy and for the well being of most Americans. If the housing didn't recover, ... millions of Americans would lose their home, which turned out to be the case. ...
There was a third problem, and that was finance. The financial system had been excessively deregulated. ...
In the early days of the crisis, it was very clear that those in the financial sector, including those that were advising the president, wanted to pretend that there was just a little bit of a perturbation in the housing market. It had gone down; it'll go up again. It was just a temporary aberration.
But those of us who looked at the data, people like Bob Shiller who studied the housing market, said no, there'd been a bubble. You've been living in fantasyland, and the price declines that you've seen are not going to be reversed any time soon.
Unfortunately it appears as if the Obama administration paid more attention to those who were the dreamers that the market would come back [than] to the realists who said no there'd been a bubble, and you've done some pretty bad lending, and now you're going to have to face the consequences.
Now we're four years after the breaking of the bubble, and housing prices are still 30 percent, 35 percent below what they were at the peak. Some places 50 percent. In some areas housing prices are continuing to fall. So that was a very fundamental misjudgment that had implications for everything that went on after.
One of the implications was they never put together a program to address the Americans who were losing their homes. They never did very much to stop the foreclosure movement. A small program, $75 billion was set aside, $2 billion was spent to help homeowners. It was clear that it wasn't given the priority. ...
That led to what?
That had both economic and political consequences. The political consequences were that a very large fraction of America came to the view that the Obama administration was on the side of the bankers and not on their side. How can you give all that money to the bankers who caused the crisis and not help a lot of ordinary citizens who were the innocent victims of predatory lending, of all these shenanigans? ...
Many of these homebuyers were first-time homebuyers. They took out the mortgages on the advice of the mortgage brokers, of the people in the financial sector. They sold them these financial products that exploded.
Now you could come to one of two conclusions: Either that the financial sector didn't know what it was doing, or the financial sector was out to maximize transaction cost, maximize their profits, and exploit the innocent homebuyers.
Which side do you fall on?
Both. I think actually they didn't really understand risk. We've seen that over and over again. They called themselves experts on risk; they didn't understand it.
But the thing is, they're profit-making organizations. They were out to maximize profits, and they saw some people who they could exploit. ...
What was the set of deregulations that particularly led to the problems that we have now?
... First, in the aftermath of the Great Depressions and the lessons we had to learn, there was a division between investment banks that took money from rich people able to bear risk and invest in high-return, risky activities, and commercial banks that took money from ordinary individuals, supposed to invest it conservatively, lend it to help create new businesses, expand ordinary businesses.
Two very different kinds of financial institutions -- and there were a whole variety of reasons for that separation, but the most important was we'd learned that when you bring these two things together, you have conflicts of interest, very bad behavior. ...
The second aspect was not so much deregulation but not adjusting the regulatory structure to the changing needs of a increasingly more complex financial system. So the other big mistake was that in the '90s these complicated financial products called derivatives -- things that Warren Buffett referred to as "financial weapons of mass destruction" -- had started originating. ...
The repeal of this division between investment banks and commercial banks led to [several] problems. First, the cultures of the two were very different. The investment banks were undertaking risky activities for rich people. The others wanted to be conservative. When you brought the two together, the mentality that prevailed was the risk-taking mentality.
So what we had was banks like Citibank, that used to be a commercial bank, buying all these risky CDOs [collateralized debt obligations] and other risky products which blew up, requiring again a massive bailout. ...
The second [problem] is you have conflicts of interest. When banks are both issuing new securities and lending, you have all kinds of risk to our financial system. You can lend to a company to make sure that it looks good, and you want it to look good because you just issued the shares. ...
The final problem was called "too big to fail," that when you allow these banks to get together you got bigger and bigger banks. ... If you let them fail, it has an enormous effect on our financial and therefore our economic system. ...
You've said very clearly, "We caused this crisis." You, the banks.
Well, the financial services industry. It really [was] what people refer to as banks -- because, you know, investment banks. But what really it was, it was the noncommercial banks, or those that we call deposit institutions. It was investment banks, primarily, and savings and loan associations.
The role that derivatives and financial innovation played in destabilizing the banking sector, or the financial sector as you would put it, what were you seeing? As this was going on, what were you thinking?
Well, there's nothing wrong with financial innovation and derivatives and so on if they are properly done, properly understood, and, I guess most importantly, properly rated by outside parties who are supposedly objective and you can rely on them.
And I think one of the most important reasons that this crisis got as big as it did is that these, the exotic forms of these particular instruments, incomprehensibly some of which were rated AAA by the rating agencies -- I cannot imagine how they could come up with subprime mortgages AAA-rated.
And therefore, particularly when it's AAA-rated, people don't do due diligence. I mean, they say that they're off by a little bit, so then they're only AA. (Laughs.) It's still -- they just bought this stuff.
And I'll make this statement, that if the rating agencies had not rated so much of this, what I would call toxic subprime mortgages, AAA, this crisis would have been small enough to be manageable and would never have gotten to the size it did, if just the rating agencies had done their job.
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.
... Had it not been for credit derivatives, how serious would the financial meltdown have been?
It's very hard to say. It's a tough question to answer, because the backdrop for the whole financial crisis was a complicated set of circumstances. One is investors had become very complacent about everything.
I've talked to other of your colleagues who have agreed that that was in part driven by the idea that you could always just sort of write another insurance policy; you could insure yourself. But finally we found out that people that were holding those insurance companies had no capital, couldn't pay up.
You're right. There was real complacency all around. There was a real search for incremental yield or incremental return, and combined with complacency was a very dangerous thing.
How much of that complacency ... was driven by the fact that everybody had laid off the risk through the use of credit default swaps?
I don't think that was a central feature. I think the complacency came about because nobody could imagine house prices dropping by 50 percent or 60 percent. Nobody could imagine interest rates being increased by 3 percent in a short period of time.
But had those things happened and everybody not having been sort of tied together with all these insurance contracts, would the damage have been the same?
I think if for whatever reason derivatives had never existed -- either nobody thought of them, or some regulator at some point in the '80s said, "There will be no derivatives," a little bit like what the Chinese say today -- what would the AIGs of the world had done instead?
What they would have done instead, most likely, is lent a huge amount of money to borrowers in the form of subprime mortgages. And in fact, what they probably would have done was lent the money to owners of this mortgage pool and that 30 percent or 50 percent loan-to-value mortgage.
Explain the role of leverage in making all focus this worse. And how did get to the point where banks could really take so much risk, and have such low capital levels?
Leverage is an important piece of the puzzle because it enables the banks to take on much bigger bets. So if they are only using their capital, then they have leverage of one-to-one. For every $3, they make a $100 bet, they're leveraged more than 30-to-1. And it will only take a 3 percent loss, a relatively small loss, to wipe out all of their capital. So leverage is important because it magnifies the bet. …
I actually think that the role of leverage in the financial crisis has been overstated. I think that banks have been massively leveraged throughout history. During the 1990s, banks were massively leveraged. …
I think the one thing that has changed dramatically is that we aren't able to tell how much leverage there is at banks, that it's not as simple as looking at their financial statements and saying, "Oh, look, they're leveraged 40-to-1 instead of 30-to-1." Or, "Look, they're now 30-to-1 instead of 25-to-1." I think we're looking at the wrong issue if we look at their financial measures of leverage.
I think the big thing that's changed is the extent of off-balance sheet exposure. The amount of leverage in some of these super senior positions is infinite. It's 100 percent. There's no capital put down. AIG had unlimited leverage for many of its positions. …
I think that the distinction between Goldman and Citigroup is particularly interesting because I think Goldman showed itself as being a very sophisticated actor that understood the risks in the financial markets. It's certainly been a vilified bank, and some employees engaged in unacceptable conduct. But the folks at Goldman were smart.
The folks at Citigroup were not smart. They did not understand their bank's exposure, even at the very end when they were in an almost Keystone Cops way trying to figure out what to tell the regulators, what had gone wrong, and what are they going to tell investors.
To me, one of the most surprising things about Citigroup is that their senior leaders, their CEO and the CFO, were willing to sign their names certifying the accuracy of their financial statements in late 2007 and early 2008, when the bank was completely out of control. They signed a testing that there were adequate internal controls when Citigroup couldn't understand and evaluate its risk. And the regulators were involved in that, and ultimately found that there were risks within Citigroup that Citigroup didn't understand, it didn't adequately control.
I think it's really interesting that often, we tar Wall Street with all of one brush. But if everyone had acted like Goldman, we wouldn't have had a financial crisis. If everyone had acted like Citigroup, the financial crisis would have been much, much worse. And I think it doesn't serve policy well to paint everyone the same way. I think what we want to try to do is to make sure the financial institutions don't ever act like Citigroup acted again. …
[Critics say that] so many of these deals seem to happen, from their point of view, in secret. They keep saying black box, black box, it was impossible to know who were the counterparties. …
I think that point is correct. The fact is that the regulatory framework in the United States … was designed for an era that ended decades ago and is one that is very much defined by either products or corporate entity charters.
So even though your activity may look the same irrespective of whether you're an insurance company, a banker, a broker/dealer, hedge fund, a private equity company, your regulatory framework, your restrictions, your legal powers are utterly different depending on what your corporate charter looked like. And that's wrong, because the essence of intelligent and effective regulation needs to be that similar activities should be subject to similar regulation, indeed, the same regulation for lots of good reasons, one being the efficacy of the regulation, the other being the leveling of the competitive playing field, incidentally, which is another topic. …
I think that the thinking that got people comfortable erroneously, with hindsight, with that outdated framework was that somewhere there was an overriding commercial incentive that would govern the behavior of all of these outfits and cause them to defend their own positions, their own shareholders, their own capital, and that that was an adequate incentive for insuring that people did not engage in self-destructive behavior. That, at the end of the day, only matters if the self-destruction brings down others.
Unfortunately, what became clear is that either because people didn't understand the risks that they were engaged in, or because they were under such competitive pressures that they were unable to react wisely to them, self-destructive behavior actually occurred. And that self-destructive behavior, which under normal circumstances one should let it flow and the destruction should occur, became systemically consequential because of the linkages between all of these companies.
They all became "too big to fail."
Not necessarily "too big to fail," but too interconnected. …
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