What was on Bear Stearns' books that was scaring [Tim] Geithner and Bernanke?
Well, I would say that unfortunately none of it scared them until the market seized up with lack of liquidity. I wish it would have scared them -- (laughs) -- and it would have stopped it.
But it was scaring somebody. The market, the investors were scared, pulling their money out. Therefore there was a liquidity problem.
Yeah, but that's my point. It wasn't until the liquidity occurred that it appeared that the regulators got on this.
So you think Geithner and Bernanke were pretty clueless about what was happening over at Bear?
You'd have to ask them. I would say this: The primary regulator of Bear Stearns is the SEC [Securities and Exchange Commission]. Geithner was head of the New York Federal Reserve, and Bernanke was the chairman. So it's not that they couldn't have known or shouldn't have known. The one that should have known what was going on and totally failed was the SEC.
Did you know what was on their books?
You knew that they were holding a lot of these complex financial instruments, CDOs [collateralized debt obligations], synthetic CDOs?
And did that scare you?
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 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. ...
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. …
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. …
So should Bear have been let go? Should Lehman have been let go, but also in a smarter way?
What we did with Bear is we kept it alive but within JPMorgan. That was a case where we took the position of preserving the institution but not the shareholders and the bondholders.
But the way we did it was not transparent. The cost to the taxpayers almost surely was greater than was necessary. And I think there's a very heavy cost to our democracy when we don't do things in a transparent way.
In the case of Lehman Brothers, I think we should have followed the same kind of thing, save the institution but not save the shareholders, not save the bondholders.
And this inconsistent pattern -- AIG we should have done the same thing. When it came to the CDSs, part of bankruptcy is they wouldn't have been honored. They would have gone with everybody else. And if that put Goldman Sachs into bankruptcy, well that's part of the cost of letting the shareholders and the bondholders pay the price. It would not have gone into bankruptcy; it would have only meant the shareholders would have lost and the bondholders would have become the new shareholders.
Same thing in Citibank: If we hadn't rescued Citibank, there was enough long-term debt to have kept it going. It's only the shareholders would have lost and the bondholders would have become the new shareholders.
People will argue that if you had done that, if you had let all these things go in that way, then credit would have dried up immediately everywhere, that banking systems around the world would have stalled to a stop, that economies would crumble.
There is no evidence of that. The institutions would have been preserved, and in fact they would have had more capital, more equity if we had turned all of the debt into equity, over $300 billion in the case of Citibank. That's more money than the U.S. taxpayer put in.
It's an example of the kind of scare tactics that Wall Street has used repeatedly to get the money to hold up the American taxpayers, to hold up taxpayers in other Western governments. ...
In America [Lehman Brothers Chair and CEO] Dick Fuld is not going to be too concerned ... that there's a chance that the government would ever let him go?
The moral hazard was so deep that I think there was a widespread perception that somehow all the banks will be saved. ...
Bear Stearns in a sense was saved; it was folded in to JPMorgan. But the shareholders, the officers lost a great deal, and they're very angry because if the Fed had extended the lending rights to Bear Stearns that had extended the next day to the other investment banks, they believe they would have survived.
Whether that's the case or not, I don't know. But certainly there was a very strange timing there of extending privileges on one date to some and not to another.
Rumors were going around about what was the reason, going back to one of the earlier Fed-engineered bailouts, Long-Term Capital Management at the end of the '90s. The story was Bear Stearns didn't play game, and they were going to be punished.
So a lot of people on Wall Street didn't really care that much when they went down because they thought they got their comeuppance.
That's right, but that also sent a warning: Maybe if you're not playing the game, the Fed picks and chooses, picks winners and picks losers. ...
There were rumors after Bear Stearns went down that Lehman was going to be next, and that's where you have the next moment of incredulity. The Fed seems to have been taken by surprise when Lehman Brothers went down. It seems to have been taken by surprise at the consequences of Lehman Brothers going down.
To many of us, this was a mystery. The bubble broke in 2007. That's when you should have started getting worried. You should have known what their portfolio was.
When Bear Stearns went down, the common wisdom was Lehman Brothers was going to be next. Shouldn't you have been looking at the full consequences if Lehman Brothers went down? Talking to people on the staff, it seems not to have fully appreciated the risks of what went on.
When it happened, the first line of defense they said was: We thought the market had time to adjust. Again this blind faith in the markets, just like markets manage risk -- they should have learned about that.
Then they said: Well, the markets were seeing what was going on. … Data on the freezing of the financial markets, interbank market in the period before this should have sent a clear signal that markets were not really well prepared.
So then they came to their second defense: We didn't have the legal authority to do anything. That also had seemed very funny, because two days later they bailed out AIG.
Now all of us thought the Federal Reserve was supposed to be dealing with commercial banks, and then they extended their purview to investment banks. But then AIG, an insurance company?
If they had authority to do what they did with AIG, clearly they had the authority to deal with Lehman Brothers. And if they didn't have that authority, wasn't their responsibility back in 2007, when the problems arose, to go to Congress and say, "We don't think we're going to need this, but just as a matter of precaution, please change this line in our authorization." They didn't do that.
In the end, you have to say they really didn't do what they should have done.
... 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. ...
So as Bear Stearns melts down, what position did you take on what to do about it?
We, being the FDIC and my peers, were not involved.
I got a call on Friday, early in the morning, from one of my staff. He had been notified by somebody at the Fed that [Bear Stearns was] going to go into bankruptcy, and then when I got into the office the narrative had changed. Now there was going to be this government-assisted acquisition by JPMorgan Chase of Bear Stearns.
My reaction when he called me that morning and said they were going into bankruptcy was, "Well, investment banks fail." Because they do. That's the traditional model. Insured banks are supposed to take deposits.
I was surprised that the government had to assist with the acquisition and had taken on risk exposure to assist with the acquisition of an investment bank. It amazed me because the FDIC is the only agency with express legal authority to wind down financial institutions other than Fannie and Freddie. Their regulator has control, and of course ours only extends to insured banks.
So we have ... rules and procedures that we have to go through, and we are really forbidden from doing anything to help shareholders. … Our rules say if the place is going down, they go into receivership, which is just like a bankruptcy, and the shareholders and the unsecured creditors absorb the losses associated with that. ...
So I was very surprised that the New York Fed had found legal authority to go in there and arrange a deal. We auction things too. We never just call up an entity and say, "Will you buy this place?" We might call several entities and say, "Would you be interested," to get an auction going, but we never kind of just arrange marriages. ...
... Did you call up Tim [Geithner] and say, "What's going on?"
Again, it was an investment bank. I did not have any authority over Bear Stearns.
But you knew more than anybody else in the government about what it meant to take down a bank?
We did, and it would have been nice I think if we had been consulted at least on some of these issues.
You were never consulted?
Not outside insured banks, absolutely not. We had nothing to do with Bear Stearns, Lehman Brothers, AIG, none of that. ... We were consulted on Fannie and Freddie, but not the other ones. ...
I think that's regrettable, because I think there're some things where our insights and rules could have maybe helped with perhaps making the bailouts not so generous at least. Granted, government had to take some action. ...
It would have been at least nice for there to be some publicly available analysis. ... Why was it necessary for the government? What did the New York Fed see about Bear Stearns failing that convinced it that it was going to be systematic. Who was going to take losses? What would the knock impact of that been?
Throughout the crisis I was very frustrated that I just kept getting these arguments when we started being asked to participate in bailouts. When institutions like Citi got into trouble, I got very frustrated with these categorical statements: "Because they're big. They're systematic. And we've got to bail them out." That wasn't enough for me. Just because you're big doesn't mean you should get showered with government money.
I want more analysis of why. If I'm going to go in there and give exposure for the FDIC, which is a government agency, why am I doing that? Who am I protecting? I don't want to protect this institution. They were badly managed. They should fail. So who am I protecting? ...
Going back to Bear, when Geithner, who is really handling that one, sees the hole in Bear, how surprised is he, and how extraordinary [is it] that he was surprised?
Well, I think it's extraordinary that he should have been surprised, given how many assets they had in mortgages, in subprime and what's called Alt-A mortgages. And, you know, when things go at Bear, they go fast. They start the week of their collapse with about $18 billion in cash, which is less than the other institutions. But within five days it's gone, as essentially there is a run on that institution.
In a sense, runs happen very quickly. So when they start, they gather tremendous velocity. As I noted earlier and I will just repeat, right after Lehman, Morgan Stanley goes into meltdown. They go from $130 billion on hand to about 55 billion. Goldman Sachs within one week goes from 120 billion to 57 billion.
Some could argue, hey, when runs happen, they happen fast, so the policy-makers had to act quickly. But I think what's most troubling is the extent to which they didn't see the fundamental rotting in the system that had manifested itself for years. And it was clear, I think, and evident to many people in the marketplace by the end of 2006.
And remember, this didn't happen in a vacuum. By the end of 2006, many of the biggest subprime lenders in this country are beginning to go out of business. At the beginning of 2007 New Century blows up, so, you know, there is lead time here. Now, I think the real story of this financial crisis is probably not so much whether the bailout was the right thing to do or the wrong thing to do. The real question is, how did it come to be that this nation found itself with two stark, painful choices, one of which was to wade in and commit trillions of dollars to save the financial system, where we still end up losing millions of jobs, millions of people lose their homes, trillions of dollars of wealth is wiped away, and the other choice is to face the risk of total collapse? I mean, that's the real story. How did the policy-makers, our government leaders, the financial sector maneuver this country into that kind of corner?
Talk about Bear Stearns. You have a problem with the way it was handled. ...
... One [concern] was that right after Bear Stearns was allowed to go, the Fed decided that it would start lending to investment banks. The Fed's charter had always been the commercial banks. The mantra in the deregulation days of the 1990s was investment banks should be left to do their own thing; commercial banks we ought to focus on. Investment banks can manage their own risk; if they go bankrupt, it's not going to have systemic consequences.
Well that story seemed to go by the wayside overnight when the Fed said no, investment banks are systemically important, and we will lend to them as if they were just like a commercial bank.
They saved Bear. Also it's been found out ... there was an extra $30 billion given to them to help them survive in the in-between while the deal was going through. How does that knock to hell the whole idea of moral hazard?
Clearly the problem with moral hazard had been festering in the financial sector for years.
We -- the United States government, the IMF [International Monetary Fund], the European governments -- had been bailing out these big financial institutions over and over again. We did it in the early 1980s with the bailout in Latin America. We did it in '95 with the bailout in Mexico. We did it in East Asia with the bailouts in Korea, Indonesia, Thailand. We did it again, the bailout in Brazil. We did it again in the bailout in Russia. We did it again in the bailout in Argentina.
There's a pattern here of reckless lending over and over again by these major, large financial institutions, and each time taxpayers bail out the banks; the banks get their money. ...
Let's go back in history and then take it chronologically now. So 2007-2008, you're the chief economic adviser. When did you guys know that, lo and behold, we might be holding a bag of stuff we don't want to hold, coming up soon? What were you debating? What were you talking about? And how slowly did the conversation you were having get more and more serious about a possible crisis?
I would say there are about two different eras through the campaign. The first thing I'll note is way ahead of me, way ahead of any of the advisers or any of the people on Wall Street, then-candidate Obama was well, well ahead of the curve. He had sent letters to Secretary [of the Treasury Hank] Paulson and to [Chairman of the Federal Reserve Ben] Bernanke, asking them to look at subprime mortgages, that there could be a brewing crisis.
In the summer of 2007 and going into the fall, the president goes and gives a speech at NASDAQ in which he says: "Number one, Wall Street is not an island. If the middle class can't pay their mortgages, you may think that is not going to reach you, but I assure you it will. We're all in the same economy. I'm going to be for a middle-class agenda, and you shouldn't be against it. You should be for it. And number two, it doesn't make you anti-business or anti-market to be for stronger rules of the road and a sound regulatory financial system."
No two points were ever more worthy, and no two points were ever more central to a financial crisis than that. That was the fall of 2007. After Bear Stearns in March of 2008, we're in the middle of an epic primary campaign between [then-Sen. Hillary] Clinton and Obama. Obama goes and gives a speech with [former Fed chair] Paul Volcker sitting right in the front row at Cooper Union in which he goes through in great detail, "Here is how we should re-establish rules of the road and regulation of financial system."
It's March of 2008. In the audience are primarily political journalists who are all looking at each other and saying, "Why is he talking about Fed oversight?" It was not on the radar screen of the political system. But it was on the mind of the president, because everywhere he was going, this was the natural culmination of the public is losing trust in the financial system. And when you lose public trust in the financial system, what tends to happen is everyone pulls their money out. And that is the essence of what the financial crisis was.
So I would say the president was definitely concerned about the potential for crisis all throughout 2008 and demonstrated that [by] giving speeches on the subject. By the summer of 2008, in running up into Lehman, through Robert Wolf, [Obama adviser and president and COO of UBS Investment Bank], through some other connections of people that he was talking to as well as talking to the economists, people were on pins and needles, because we knew if the credit system collapses, the country could be in for a real bad recession.
And then, after the events of Lehman, the doors blew off. Then at that point, we knew we had had a series of midnight-to-3:00 a.m. phone calls throughout the summer comprised of a lot of major-league names in finance and economics. Paul Volcker, he didn't have a cell phone, and finally they demanded that he get a cell phone, because there were so many times we were trying to reach him at midnight or whatever time that he had to do that.
By the fall of 2008, Secretary Paulson and the administration are calling then-candidate Obama, and they are saying: "Look, we think the world is close to coming to an end, and we really need your support. What do you want to do?" Both of the candidates I think were thrown into positions that are normally reserved only for people that are already the president, where they are being pressed to publicly get up and say: "What are you going to do? What do you want us to do?"
I think it is to President Obama's credit. It wasn't a secret that the TARP, that the financial rescue or any of that stuff was unpopular. That was easily understood from the second it was getting announced. The question really was, despite that being tremendously unpopular, maybe the most unpopular thing the government has ever done, do we still have to do it? And there were certainly political people advising him: "No. Well, look, why can't we demonize this?" But the president said: "It's too dangerous. We can't do that."
"The FRONTLINE Interviews" tell the story of history in the making. Produced in collaboration with Duke University’s Rutherfurd Living History Program. Learn more...