The Financial Crisis: the FRONTLINE interviews
Money, Power, & Wall Street
sponsored by Duke Sanford School of Public Policy
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.
[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. …
... What you're saying in the case of credit default swaps is they were in an unregulated space, so nobody was checking [whether] the buyers or sellers of these things would be solvent in the event of a calamity?
Exactly, and was a real dereliction of responsibility of the Federal Reserve, particularly Federal Reserve in New York, which is where a lot of this was going on.
How do you account for the fact that a lot of smart people made this miscalculation?
I think it has to be self-interest. They were captured by the financial market.
And making a lot of money?
Those in the financial sector were making a lot of money.
The regulators don't make any more money.
The regulators were what we call "cognitively captured." They spent all the time with the bankers. The bankers said: There's a wonderful party going on. Don't spoil it. We're smart people. Trust us.
You see that mentality reflected so strongly in the testimony that Alan Greenspan gave to Congress where he said: "There was a flaw in my reasoning. I thought that the banks would manage their risk better, and obviously they didn't."
But I think actually that that position was untenable and irresponsible, because you don't, as a regulator, just trust. Your job is to make sure that if they don't do their job, the consequences for our banking system, for our whole economy, aren't a disaster. ...
I'm going to stop you there, because the other thing you said about the way the Treasury and the Fed handled the crisis was that it showed unclear understanding of the financial system. What do you mean by that?
Well, it's striking, because you would think that the people who were in charge of our financial system would have a grip on the key risks that were in it. And if they did, they would have moved, in a sense, to get a handle on those. So take the derivatives market, which exploded in size from the time it was deregulated -- you know, by 2007 there's over $600 trillion nominal value of over-the-counter derivatives contracts. Our regulators, because that market had been deregulated, had really no sense of the magnitude of risks that were embedded in that system. In a sense they had deliberately turned a blind eye to those problems.
That's one example. Another example is just not fully understanding how the risk in the subprime market could metastasize to the rest of the financial system through derivatives, through the creation of synthetic securities and these exotic instruments like collateralized debt obligations and CDO-squared; not much understanding of the risk embedded in something called the repo market, which was a $2.8 trillion market of overnight lending, which really sustained most of these major financial institutions.
There had been a deliberate decision to leave unfettered, unregulated huge expanses of our financial marketplace. And even --
By who?
Oh, it was a collective decision, but it clearly accelerated through the 2000s. But look, it began in the 1980s. It began with the deregulation of the savings and loan industry. It happened in the 1990s with the deregulation of over-the-counter derivatives, a clear and definitive policy statement that this part of our marketplace would be left in the dark. There were changes that happened as part of the Glass-Steagall Act reforms or repeal in 1999, when, in fact, in many ways, the light hand of regulation was embedded in the practices of regulators.
And, of course, through the 2000s you had instance after instance where regulators failed to spot problems or repeatedly assured the public that things were OK. For example, the Securities and Exchange Commission had the full authority to control leverage at the major investment banks. This is how much they were borrowing on thin capital. Yet they chose not to act.
Some would argue that banks are so essential to our lives that they are akin to utilities and therefore should be more heavily regulated than they are.
The problem isn't lack of regulation. Banking, I would argue, is the most heavily regulated industry in the world.
Regulations don't solve things. Supervision solves things. If we could figure out that the subprime thing was a train wreck that was coming, where were the regulators? ...
Everybody points the finger at the banks. That's great. They made their mistakes. But the job of the regulator is supposed to be safety and soundness.
The bank we bought in Florida, BankUnited, made a specialty out of the most toxic product that you can imagine. This was a specialty of theirs pre- our buying it and pre- the failure. What was the product? Adjustable rate mortgages. Subprime mortgages, generally pretty close to 100 percent loan-to-value with teaser rates in the beginning and then sharp ramp.
And who were their borrowers? Non-resident Latin Americans. Now I have nothing against Latin Americans, but to give a non-resident 100 percent loan-to-value loan when you know he's a bad credit and he's not even someone in your country.
That's a no-money-down loan.
Yeah, no-money-down loan to a foreigner. It doesn't make a lot of sense to me, and yet they put billions and billions of dollars of that on their portfolio over a period of years. Nobody stopped them. That kind of thing is an abject failure of supervision. ...
When do you call Obama? When do you sort of say, "Maybe I should talk to--"?
So I was speaking to the senator all along during that three-day period, but not that dissimilar to -- I was speaking to him prior to that period as well, although there were probably a few more calls that day than other days. He was privy to the meeting, based on, you know, everyone heard about the meeting. So, one, he was privy to the meeting; two, I believe he may have engaged Paulson or people at the Fed at that time. I think it may have been Paulson.
But I was letting him know that, "Listen, this is what could happen." We weren't talking as much about Lehman being saved, because if Lehman was saved and everything was fine, then it would be good. His questions were much more directed: "OK, what if Monday opens up and the announcement is a Lehman filing?" So when we started talking Friday night, he was asking the tough questions, not the rosy scenario. He was trying to figure out, "Well, what if it went the other way?" And the truth is, there was a lot of guessing going on. No one knew exactly what would happen that Monday morning.
For me, which [is] why, you know, we chatted earlier, why I think there's need for new regulations and a systemic regulator is as much as we talked about Lehman, for the most part neither the Fed nor the Treasury was the Lehman regulatory; it was the SEC at the time. I'm not so sure that they had the tools to be the regulator for a global financial institution like Lehman, who has a trillion-dollar balance sheet 35 times levered.
Somebody listening to this is going to say: Wait a minute. I thought it was the lack of regulation and the failure of regulators that got us into this mess, and now you're saying that we're going to be in a bigger mess because we have too much regulation.
There's a big difference between regulation and supervision. None of the new regulations in my opinion, other than separating the proprietary trading and kinda trying to ring-fence that, ... other than that, there's not one of these new things that would have prevented any of the failures. So most of it is nothing to do with the cause of the failure.
But what about preventing a future failure?
I don't think it will do that either, because there was nothing in the old rules that would've prevented the regulators from saying to BankUnited: You shouldn't be making such a big concentration of those loans. Or the bank in Georgia making all these hotel loans. They didn't need a new regulation to do that.
I think that's an unfortunate thing that the public does not understand. Regulation and supervision are not the same things. What supervision requires [is] somebody sensible and thoughtful to come in and say, "Is what these people are doing something that's sensible or is it not?"
That's different from saying, "Okay, this is a category two loan, do you have the proper reserve against it?" Supervision is a question of applying judgment. You don't need more regulations to have proper supervision.
What you're describing sounds to me like an art form, supervision. And what we get is we try to make a science out of fixing the banks.
But it's not a science. It's common sense.
But do we have the artists? Do we have the people that can really do the supervision you're talking about?
I think so. I just think it's a question of what is our mind-set? There was too liberal a mind-set before. The idea was sort of anything goes. ...
Now there's too much of a punitive attitude, where anything the bank does is bad. Like, for example, Bank of America. When the Durbin Amendment took away a lot of their credit card fees, they started imposing some new charges, and the government went berserk. President Obama had a press conference attacking them for doing it.
What was really going on? It was a question of you had just now transferred, the government, part of my profitability away. Now I'm trying to replace it. What would you expect?
Is there some truth to the fact that Washington is soft on Wall Street?
Oh, is Washington soft on Wall Street? I think yes. I do think that in 2009, the Dodd-Frank bill did make some important changes that Wall Street resisted. And the administration stood up, and the Democratic leadership in Congress stood up. But, you know, it's going to take some real work to change a culture that developed over 30 years. I mean, first of all, for 30 years, many regulators approached banks on the basis that they were not so much regulated entities as partners together, when, in fact, the job of public oversight is to exercise public oversight.
In fact, if you listen to some of the testimony given to us during the commission, regulators told us time and time again that they were urged not to be confrontational with banks. But in fact, in the end of the day, what we want are regulators who are. So that culture changes slowly.
Secondly, there is a real mismatch here. I mean, we have regulatory agencies that are understaffed, where pay is not what it needs to be to attract and keep people. What I saw -- and I really wasn't aware of this before I took this position -- but I was struck by the number of people who would work for a regulatory agency for three or four years, and then it was three or four years up and out to Wall Street.
And look, unless we have the political will to back our regulators and then give them the pay and the resources to do their job, it's going to be a mismatch. Look, Wall Street is like a greased pig. It moves fast. It's always looking for the new opening. Hard to catch. And unless you recognize that mismatch, you're going to continue to have Wall Street with victories at the expense of the American people.
The fact is that in the wake of this crisis, there has been very little rethinking of the practices on Wall Street. Why is that? Generally we learn, we grow from the consequences of our mistakes. But Wall Street was spared the consequences of their mistakes. They didn't really pay a price for those kind of practices in any real terms.
And the irony of the bailout is it may have saved the financial system, but it may have done great damage in terms of our ability to have Wall Street rethink what was right, what was wrong, what was sustainable, what was not.
And Geithner's attitude always was, "No, our role here was to save the banks." He in fact at one point says, "Coddling the banks is actually -- that's what our philosophy is." So what was the philosophy, and what was going on?
Well, I can't look into their heads. Here is what I can say. The reason we ended up, as a country, having to deploy massive amounts of money to stabilize the financial system is because there has been a philosophy of laissez-faire, a philosophy of condoning recklessness, a philosophy of turning a blind eye that allowed the magnitude of risk and therefore disaster to build up.
So much of the focus has become on the immense amount of resources deployed for the bailout, and I think that's a rightful focus. But I think it misses the larger point, which was how did it come to be that we allowed our system to take on so much risk? How did we allow these systemically important financial institutions to undertake the kind of reckless acts they did without the proper regulatory oversight that required, at the end, this level of assistance?
I mean, it just speaks to the magnitude of the disaster and the failure of financial policy in the years leading up to the crisis. That's the real lesson to be learned here. You know, at the point that the fire's burning, you call out all the trucks to put it out. The real question is, who lit the match? Why was the fire unattended? Why were the alarm bells to put the fire out early, why weren't they heeded? That's I think the real question that we have to ask ourselves.
And I think that goes back to the fact that the financial sector was so dominant politically, and the ideology, which they pushed at every turn, of deregulation, laissez-faire, light hand of public oversight, that that had been very successful for them. And that's the price that we paid, was having to deploy these massive resources.
But you had Long-Term Capital happen. You had the Bear weekend go down where both times they were able to within Wall Street and with help from the Fed to save the day. Why was there no plan?
Well, I think a couple things, which is why we go to the Dodd-Frank, and really the key parts that they're trying to work out. One, just to go back, I think you may have had a different outcome if Sunday night was Merrill Lynch saved, a Lehman filing, but something about AIG as well. There was that big elephant in the room for those 72 hours that no one discussed, which was AIG. All of Wall Street knew AIG had problems. My guess is the regulators knew AIG had problems, but they didn't have a regulator that had control of AIG that was at that table, and they didn't have control, the Fed nor the Treasury, of AIG.
So I do think that in some ways, when you look at the Dodd-Frank bill and you look at the five silos of the Dodd-Frank bill, a systemic regulator, I think, is crucial for the future success of our industry, because you need to know more than what the bank holding companies are doing; you need to know what some of the large insurance companies are doing, and other financial services.
The second thing is a resolution authority is key. So how do you wind down a global interconnected financial institution that's in a myriad of countries that have all different jurisdictions? So a resolution authority is key.
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?
Yes.
You knew that they were holding a lot of these complex financial instruments, CDOs [collateralized debt obligations], synthetic CDOs?
Yes.
And did that scare you?
Yes.
So when you say, "We caused this crisis," you're in a sense standing shoulder to shoulder with other bankers across the financial industry. So there's a view that you bear therefore, whether it was Wells or not, you bear collectively some responsibility for the crisis. But on the other hand, you're saying that it was Washington; it was regulators at fault here for failing to listen to people like yourself. So where is the blame here? Is it equal parts banks and Washington? Where do you lay it?
I'd state it this way. There has always been abhorrent behavior by financial institutions. We can go back centuries, we can go back decades, whatever it is, by some financial institutions. There always will be, and regulators seem to be incapable of stopping it. In fact, it even leads to bank failures. So I'm just assuming that's always going to be the case.
What happened here, no question, is why did it get so big? It's management. You know, you may have a few problems and issues, but it doesn't turn into the worst and longest recession we've had since the Depression. Why did that occur? That's the question.
Well, the first statement is that yes, it occurred, but primarily with 20 institutions who were investment banks and S&Ls mostly, not commercial banks. And then why did it get so big if it was only between 20 institutions?
Because of the failures of regulators is your view.
Well, five institutions. Rating agencies is not a regulator.
But they're part of the checks and balances.
Right. The SEC who regulated the investment banks did nothing about their liquidity and leverage, the federal banking regulators who had all the authority they needed to reign in, say, Citicorp. Congress -- this crisis could never have occurred [if it] hadn't been for Fannie [Mae] and Freddie [Mac]. Seventy percent of all subprime mortgages, all pay mortgages and other risky mortgages, were guaranteed by Fannie, Freddie or some other government agency. For 20 years -- I'm not exaggerating; look in the record -- I've been warning members of Congress that the portfolios and the risk at Fannie and Freddie were to such an extent that one day they were going to blow up and cost taxpayers $100 billion or more.
To date, it's cost $150 billion. I believe it's going to at least double. Three hundred billion dollars of taxpayers [money] is more than all the costs of banks, automobile companies and insurance companies by a factor of 10.
The cost.
The taxpayer costs of $300 billion, the estimate of TARP is about $30, so it's going to cost 10 times more. Where's the outrage with Congress? Every administration for the last 20 years has told Congress that Fannie and Freddie are risky. Every regulator has told them.
I think people have given up on Congress.
So why aren't we occupying Washington, D.C.?
[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. …
Why is it not traded on an exchange?
I think the reason it's not traded on an exchange is that people want to keep it in the dark. They don't want to be subject to an exchange.
Part of the reason is that these are customized contracts. They may have individual features. They might be four and a half years, as opposed to five years. They might have specific wording as to what a default is. And they aren't necessarily easily made into some sort of a plain vanilla transaction that you could put on to an exchange.
But I think one of the big reasons why people wanted to have these swaps off an exchange was so that they could be done privately, so that they wouldn't be disclosed, and most importantly, so that the swaps wouldn't appear as assets and liabilities on the balance sheet.
So back in the 1980s, there was a kind of showdown, where the regulators of accounting said: "We're looking at these swaps, and each leg looks like it's an asset or a liability. It looks like something that should be on the balance sheet." Just like a bank that loans money has an asset, and a bank that has deposits has a liability -- these are things that show up on the balance sheet. …
Wall Street mobilized in response to that, and they formed ISDA. At the time, this was called the International Swap Dealers Association. And the swap dealers got together and they said: "We cannot record these swaps on our balance sheet. It would introduce too much volatility. People would look at them, and they would be scared to death of the amount of risk that we're taking and the volatility of our income."
And they successfully lobbied the accounting regulators to push all of that off the balance sheet. That's where the idea of an off-balance-sheet transaction came from, from moving these swaps off balance sheets so they're not recorded as assets and liabilities.
And you might say, well, that's crazy. These are obviously assets and liabilities, just like a bank loan is an asset or a bank deposit is liability. But the word from the regulators was OK, we'll give in. We won't count them as assets and liabilities.
So originally, ISDA was called the International Swap Dealers Association, and it evolved over time and is now known as the International Swaps and Derivatives Association. So they kept the same acronym, but they have evolved in their name over time.
I should say it's a very effective marketing organization. Anyone who's interested in lobbying should really look to ISDA as one of the ultimate lobbyists of American history, unbelievably successful.
… But it seems unbelievable that a regulator would accept this, because ultimately, a balance sheet is important to understand if a bank is in trouble. And if you don't know how much risk it's taking or what its liabilities and assets are, you have no idea what the health of a bank is.
I think part of the problem was the banks didn't want anyone to know how healthy they were, how unhealthy they were, how much risk they were taking on. The banks had an incentive, starting really in the 1980s, but certainly building through the 1990s, to move into this new, complicated financial business. And that involved taking on a lot of risk. And they didn't want to have to tell the world how much risk they taking on. They didn't want to have to quantify it on their balance sheet.
They wanted to be able to push it off and hide it in these off-balance-sheet transactions. And that was why they lobbied so hard to make sure that swaps and derivatives would be treated differently from other kinds of financial products.
... Why were they so surprised at how big a problem AIG would become?
I think the surprise in the regulatory community about AIG was directly related to the lack of regulation of AIG Financial Products, which was not the only source of AIG's problems but was the most systemic source and I think truly the greatest source, just in terms of sheer magnitude of exposure.
It was an orphan in terms of regulation. ... Insurance tends to be very well regulated, particularly the big states have very strong insurance commissioners and departments and regulate well.
But it wasn't part of any of the insurance companies. It was stuck over in London. It was away from headquarters. The supervision, to the extent there was, went to the Office of Thrift Supervision, which had some very dedicated people, but almost no expertise in this area. ... So AIGFP was just off the radar screen for everyone.
Really had no regulator looking over the books.
No regulator with any expertise in the area. You didn't have the insurance commissioners, you didn't have the Fed, you didn't have the SEC [U.S. Securities and Exchange Commission]. ...
One of the other things that had come out of AIG afterwards that caused an enormous amount of anger when it was clearly understood was the fact that the counterparties weren't forced to take haircuts, that Geithner's plan was 100 cents on the dollar for Goldman and others. What's your view of why Geithner made that decision the way he made it? ...
... This was now in the midst of the worst part of the crisis. Lehman had failed. The Reserve [Primary] fund had failed. Fannie and Freddie had been in conservatorship. Here was AIG. Wachovia was in real trouble. So very decisive action needed to be taken, and decisive also means speed, by definition.
I assume the concern was that if Geithner had tried to negotiate -- and it wasn't Geithner's call alone; it was Treasury and the board of governors of the Federal Reserve system -- that some of the counterparties would have said no … and that there would have been then no rescue package.
The serious problem here was that AIGFP was guaranteed 100 percent by the parent company, so you couldn't let AIGFP go without the entire institution being in mortal danger. So I assume that was the reason. ...
How could regulators miss that?
I don't know. All's I can say is they missed the financial crisis. This has been happening for generations. And I believe what you have to work with is that regulators will miss financial problems. We have to make financial institution failure bearable, possible and tolerable. Because they have failed in the past, they will fail in the future, and no amount of regulation can make up for ineffective regulators.
So I just say we've got to have a process that assumes that the regulators are going to fail and financial institutions are going to fail. And how do we make sure that that failure is manageable, that it doesn't turn into systemic risk and a massive recession and so forth? I believe there are ways to do that, but we're going to have to change our process, and we're going to have to admit that regulators are not capable, with all the regulations you want to put on, are still not capable of keeping financial institutions from failing.
"The FRONTLINE Interviews" tell the story of history in the making. Produced in collaboration with Duke University’s Rutherfurd Living History Program. Learn more...
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