But at that time there were no tools. As things started to fall apart, Bank of America was going with Merrill, Barclays wasn't a possibility, what was the feeling in the room? What was the conversation that you were having with Obama about "You know what? We're in some trouble here"?
I think when we chatted on Sunday, I think it was a call where it was kind of a wow call: "Listen, Senator, Barclays pulled out. The U.K. government said no for the most part. There was an uncomfortable feeling of taking something on as big as Lehman without knowing really what's under the hood and how would they fund it and how would this would impact Barclays and this general system." And I said to the president, then-senator, we were talking, and he goes: "Well, what does this mean? What happens at the open?"
And I think none of us felt good about the open. No one knew whether it would be contained or not contained. There was a feeling that at that point, we were kind of trying to make sure we got our own funding that we needed, and that we could open and get our repos done and get the things we needed to do. And I would say at midday it's kind of, it was almost like, "OK, let's make sure we're protecting our own castle and getting our operations ready for that Sunday night of something we've never gone through before."
But the senator was asking about, "OK, well, what do you think this means?" And we were talking about AIG. Sunday night, [he] and I talked about AIG, and what does this mean for AIG, considering everyone knew they were the big elephant in the room. He was asking what type of contagion this would have, and I was clear that, from my perspective, although we had never seen anything, "I think immediately we will see the markets and funding start to dry up, you'll see a lack of liquidity, and we're going to be in a situation of the unknown." And the one thing about Wall Street is we can do very well in the known. Good or bad, we do well with clarity. In the unknown, things tend to freeze.
And that's kind of what happened. The markets started to freeze. People were nervous about other firms. Our funding at our firm and other firms started to -- everyone started to get nervous. The overnight commercial paper market became very tenuous. So we had a situation that got a little nervous, no question.
And then soon thereafter, the president -- then-senator, excuse me -- we had a call that week about AIG. I remember that he put a call together for us to talk about AIG, because during that week, I think it was at that point [New York] Gov. [David] Paterson had an announcement that they're going to give a loan of $20 billion to AIG, but most of the market knew that that loan wasn't anywhere near the size needed. And all of a sudden you started having nervousness about a run on AIG, and what did that mean.
And the president put a call together. It was myself and Volcker and I believe Robert Rubin and Larry Summers, [both former Treasury secretaries under Clinton], where we were talking about, "OK, what would happen if the contagion starts in on AIG?" And then we started to have calls the next week on -- it may not have been the next week -- but on Fannie and Freddie and how does this hit the agencies that do a lot of housing. So what I would tell you is this president was engaged before Lehman, but once Lehman hit, I think he was all over it, thinking in a proactive and prospective way of how this was going to impact the economy and the election.
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."
What did you find the reason was for why Paulson and Geithner decided that they would let Lehman fail?
Right after Lehman goes down, Ben Bernanke goes up to the Capitol Hill to testify about why the decision was made to let that happen. And what Chairman Bernanke says is that the judgment was that in the wake of the Bear collapse, they had sent clear signals that they wouldn't do that again, and the market therefore had time to adjust. So their judgment was the market could absorb the Lehman collapse. That's what Chairman Bernanke said right after the collapse.
But soon thereafter the story changed. And the story of policy-makers, whether it was Tim Geithner or Ben Bernanke or Hank Paulson, becomes that we didn't save Lehman because we didn't have the legal authority to do so. We looked at all the facts, and what we really found was, there was a decision to let Lehman go. And as it turned out, it was a decision that was a miscalculation in the sense they undersized the effect of letting Lehman go down.
We really found that they made it on the basis of political considerations. There was clearly concern about the backlash of another bailout. We determined that they made it on the basis that they couldn't find a buyer and had doubts about whether they really could, absent a buyer, save Lehman. And they made the decision because, in a sense, they did miscalculate the impact of Lehman. But our conclusion was that it really wasn't the lack of legal authority. It was a decision to let Lehman go for a variety of reasons, political, financial, their sense of the market.
I think what happened is, when they saw the reaction to Lehman's collapse and the looming and pending problems at AIG which were coming at the same time, they reversed course again and, of course, moved in to save AIG.
Let's go back to the Lehman moment and break it down a little bit more.
The report is very good at defining exactly what happens when Lehman goes down. What are the consequences?
Well, the consequences of Lehman going down, I think it goes back to what we were talking about earlier, which is that there are two consequences. First of all, there are the direct consequences from Lehman going down, the direct consequences, which is they have 900,000 derivatives contracts with other parties; they have relationships with other institutions. But more than that, the policy-makers have sent inconsistent signals. They saved Bear; they didn't save Lehman. So the marketplace doesn't know what to expect.
And there's no doubt, in the wake of Lehman, there is real panic in the marketplace. But I will say this, that whether or not Lehman went down or not, the marketplace was so infected with toxic assets that whether or not Lehman itself goes down, this country still faces a dramatic, dramatic financial crisis.
Did this administration miss its opportunity when they had the leverage, they had the power to make bigger changes? Did they lose that opportunity? And if so, why? Was it simply fear that we were in such a crisis that they couldn't move too radically or else the whole thing could come down?
Well, I can't look into other people's decision making, but I do think that there was an extraordinary opportunity to remake the financial system in a dramatic way in the immediate wake of this crisis. I don't [think] the opportunity is fully lost because the country is still suffering greatly. I'd like to view it as dramatic change delayed, not forever lost as an opportunity. But clearly, in the wake of the crisis, when banks only survived through the kindness and the willingness of the American people to [for pay] trillions of dollars to support them, clearly in that context there is greater opportunity to change.
And make no mistake about it, no matter what you hear from revisionists today, almost every financial institution was on the precipice of collapse in the fall of 2008. There are those who now say, for example, at Goldman, "Oh, we would have probably made it anyway." If you listen to Ben Bernanke, he's pretty clear that of the 13 biggest financial institutions in the country, perhaps only one would have survived.
I think Secretary Geithner himself has admitted that every major financial institution was on the way to collapse. You know, it's interesting. In the week after Lehman, Morgan Stanley goes from having about $130 billion in liquidity, cash, in one week to about $55 billion. Goldman Sachs -- supposedly bold, strong investment bank -- goes from $120 billion cash on hand to $57 billion. All these institutions were about to collapse, and they never would have survived but for the trillions of dollars afforded them by the taxpayers.
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?
They want to look at the master contracts for the derivatives. And you guys find e-mails that define what? What is the fear of asking for those contracts?
The fear is the mere asking [for] those contracts will set off panic and will set off panic that there is a view that Lehman is in trouble, which of course people in the marketplace know. And it is really quite telling, because what's striking about it is, here we are a month out from the deluge, the implosion, and we don't even have, as a country, in our regulators and our policy-makers the basic knowledge that they need about how our financial system operates.
You know, there had been a dramatic transformation of the financial system from the 1980s…
How prepared were our Treasury and the Fed -- [then-Treasury Secretary Hank] Paulson, [Chairman of the Federal Reserve Ben] Bernanke, [then-President of the Federal Reserve Bank of New York Tim] Geithner in New York -- before this crisis? What did you guys find?
Woefully unprepared. I think that was for me one of the biggest revelations of the year-and-a-half investigation that we undertook. What became clear as you look at the record is the extent to which the people who were charged with overseeing our financial system really didn't have a sense of the risks that were embedded in that system that could collapse our financial system and, ultimately, our economy.
And there's instance after instance where the folks who were in charge, who were charged with protecting the public, are caught completely by surprise. Of course, in 2007, in the spring and summer of 2007, Hank Paulson and Ben Bernanke reassure the public consistently that there is really no chance that the problems in the subprime market will spill over into the larger economy. And of course that turned out to be wholly wrong.
A good example is in July of 2007, when one of the first real signals of trouble to come happens, and that is the hedge funds that are run by Bear Stearns blow up. And then there is a meeting at the Fed about the implications of that. And what you read when you see what happened in that meeting is the view is that Bear Stearns is relatively unique, when, in fact, now we know that the holdings of major investment firms in these toxic subprime securities was pervasive.
You see that it's only in August of 2008 the Treasury claims that it fully understands the depth of the problems at Fannie Mae and Freddie Mac, literally weeks before the government decides to seize those entities. It is only a month before Lehman collapses that the New York Federal Reserve, the Federal Reserve Board of New York, decides that it had better look into the derivatives positions of Lehman Brothers, who had 900,000 derivatives contracts, and only one month before they said, "We'd better get a handle on this."
And of course then they're afraid to ask for the information from Lehman, lest they set off panic in the marketplace.
Not so many months after Bear Stearns had been bought at a bargain price, why was Lehman Brothers allowed to fail?
I don't understand that. ... I think they thought they were going to do a sale to Barclays, and there really wasn't a plan B. … I think they felt there were legal constraints, and why they didn't have those with Bear Stearns but did have them with Lehman, I don't know. …
That's remarkable to me. As chairwoman of the FDIC at the time, you still don't know why they allowed that to happen?
Again, we were consulted when there was a major insured bank involved. We really were out of the loop when you dealt with all these big non-banks. …
The decision to let Lehman fail -- what was your view, and what were the complications?
... Lehman's failure had unknown consequences, and you see this occur within 24 hours. I think if anyone had said ... that if Lehman failed, the largest money market mutual fund would fail within 24 hours, and that in turn would likely take down the entire money market mutual fund industry, there may have been second thoughts.
But I do want to come back to the question of was there a decision to let Lehman fail. I think the decision was that Lehman could be rescued without the government having to put in much, if anything, in terms of support. And the judgment that Lehman could be rescued was flawed -- not totally flawed, because in fact Paulson pushed the other banks to provide substantial support for Lehman, and they had committed to something in the neighborhood of $45 billion among them to support Lehman and to provide a foundation for Barclays to acquire Lehman.
But then the whole issue came up as to whether the British government would permit Barclays to proceed. … The specter of the Asian markets opening at 8:00 on Sunday night was the deadline. When it became clear about noon on Sunday that Barclays was not going to participate, there was no option left.
Why did it come down to this one weekend? Why hadn't they planned for this? ...
The failure to work out something in advance probably has several contributing factors. One, ... if you start talking about a rescue, you precipitate the need for a rescue. So I think there was a reluctance to be too aggressive in bringing the banks together, saying we need to save Lehman.
There's also a view that decisive action can only be prompted by a crisis, so you almost let a crisis go. I think maybe people had been given a false sense of optimism by the ability to save Bear. But there was no JPMorgan at this point.
One clear failure was of communication between the U.S. government and the British government, and perhaps the blame is equal on both sides. It's probably also to the private sector, because the private sector should have been encouraging the two governments to talk. I think there was probably a presumption in the private sector that the two governments were talking, which was clearly not the case until the very end.
So mistakes get made, and when you have to make decisions and take action within an extraordinarily confined period of time, the potential for those mistakes is multiplied.
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. ...
... 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.
You've been quoted as saying that you thought maybe to some extent the Lehman lesson was overlearned. What'd you mean by that?
I think one of the mistakes that policy-makers can make when it comes to financial market oversight is to worry that these institutions are so fragile that if we put down any rules of the road, they'll go to Europe, or they'll go to China, or they'll shut their doors and that'll be it. And that's a kind of overlearning this Lehman lesson, such that you treat these folks with kid gloves.
And ever since Adam Smith, the founder of modern capitalism, it's been widely known -- and I think we've forgotten this, but it should be widely known -- that financial markets are actually inherently unstable. And if you believe that they can police themselves, which was a very much Greenspanian kind of belief that started to dominate over the last few decades, you're going to be right back where we were, with the same kind of credit bust-and-boom cycle that have taken this economy down more than once now.
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