Bull by the Horns

by Sheila Bair

  The intensity of emotions emanating from the faces of those frightened people was overwhelming. I’ve always had protective instincts. (Staff at the FDIC jokingly called me “she-bear,” in reference to my fierce defense of the staff when I thought they were being mistreated or unfairly criticized.) Their vulnerability and their obvious need for help from the powers that be touched me deeply. Up to that point, I had approached loan modifications in the abstract, from a macroeconomic standpoint: we needed to get the loans restructured to minimize losses and prevent unnecessary foreclosures that would hurt the housing market. Here I was confronted with the human tragedy of the subprime debacle. I tried to be calm and reassuring, but the desperation in the faces looking up at me made me want to break down and cry.

  After my remarks, I visited the individual servicers’ booths, where people were lined up to apply for loan modifications. I wanted to see for myself whether servicers were following up on their commitments. I unobtrusively approached a booth being manned by Litton Loan Servicing. Seated at the table was a nurse with a 2/28, who had never been late on her mortgage, but her loan was scheduled to reset. She explained that she supported her elderly father, who was with her. She was already working double shifts just to make ends meet, and she could not make the higher payment. After verifying all the information she gave him, the Litton representative agreed to give her a two-year extension. I challenged him on the spot, asking why she wasn’t getting the five-year extension, per the Treasury agreement. He was operating under instructions from his superiors, he replied. I couldn’t believe it. After all that time and effort fighting for a minimum five-year extension, the servicers were still pretty much doing what they wanted.

  When I returned to my office in Washington, I called Larry Litton, the head of the firm, to complain. He told me that the nurse’s mortgage was held in a pool where the investors would not agree to an extension longer than two years. The irony was that Litton Loan Servicing actually had one of the highest rates for loan modifications at that time, but its efforts, like those of the others, were falling far short. And one of the many obstacles—as it was with the nurse in California—was resistance from triple-A investors. Fannie Mae and Freddie Mac, which owned nearly a third of the triple-A mortgage-backed securities packaged by Wall Street, could have exercised leadership in supporting systematic loan modifications, but they didn’t. They just didn’t want to give up the prospect of those resetting higher rates.

  As was the case with most of the government’s response to the subprime crisis, Hope Now was too little, too late. Subprime foreclosures were already starting to spin out of control, and the spillover into the prime market was becoming evident by the end of 2007.

  In early 2008, we took another run at Treasury with a more aggressive program called Home Ownership Preservation (HOP) loans. Under the proposal, the government would provide low-interest loans to borrowers with unaffordable mortgages, which we defined as loans where the payment exceeded 40 percent of the borrower’s gross income. They could use the loan to pay down up to 20 percent of their principal balances. The borrowers would also be given a five-year grace period before they had to start paying the government back. In return for paying down 20 percent of the principal, however, the investors who held the loans in their securitization pools had to agree to permanently modify the loan to keep the payment below a 35 percent debt-to-income (DTI) ratio. If the borrower defaulted, the government would have first claim on proceeds from liquidating the house. Since the government’s loan covered only 20 percent of the mortgage, there was little chance that it would have to take a loss. The program was designed to entice mortgage-backed investors to agree to meaningful restructuring of those unaffordable mortgages in return for getting immediate cash to pay down 20 percent of the principal.

  But there again, investors balked because they didn’t want to give up their priority claim to foreclosure proceeds, and the Treasury Department had no stomach at that point for any program that used government money, even one where it would be virtually impossible for the government to lose money. So we watched helplessly as the mortgage market continued to deteriorate and subprime foreclosures escalated, ravaging low- and middle-income neighborhoods. Industry recalcitrance, regulatory squabbling, and Treasury’s indifference had impeded the bold steps that were necessary to get ahead of the curve.

  The year 2008 would bring with it economic Armageddon, trillions of dollars’ worth of investor losses, the largest bank failures in history, and a choke hold on credit flows to the real economy that would end up costing more than 8 million people their jobs. It didn’t have to be that way.

  CHAPTER 7

  The Audacity of That Woman

  Though our regulatory colleagues viewed us as being alarmist over the growing subprime crisis, in fact, even I did not fully appreciate at the end of 2007 how deeply some large financial institutions were exposed to mortgage-related losses, how badly some of them had been managed, and how cataclysmic the consequences would be.

  My first clue was the structured investment vehicle (SIV) fiasco, which occurred in August 2007. That was when the canary in the coal mine started gasping for breath. A number of large financial institutions, led by Citigroup, started having trouble accessing enough funding to support their mortgages and MBS investments. Citi and a few other large banks had set up something called “structured investment vehicles” as a way to invest in mortgages and mortgage-backed securities. For reasons that still today remain a mystery to me, they were allowed by their regulators—the Fed and the OCC—to keep the investments off balance sheet, meaning that they were not included in the financial reports insured banks filed with us, and, most important, they were not required to hold capital or reserves against those assets to absorb losses. Indeed, our examiners did not know anything about SIVs until the Federal Reserve Board alerted us to Citi’s difficulties.

  Here was the problem: Citi’s SIVs issued “commercial paper”—extremely short term bonds of usually thirty days or less—to finance the acquisition of mortgages and mortgage-backed securities. It was nothing short of idiotic for Citi and others to be funding such long-term assets with very short term bonds, but they did so because the rate they had to pay investors on short-term commercial paper was much lower than what they would have paid on bonds of multiyear duration. So that maximized their “spread,” the difference between the interest rate they paid on the commercial paper and the amount they received on the long-dated mortgage assets. The problem was that extremely risk-averse investors, such as money market mutual funds, bought that commercial paper, and as mortgage delinquencies started to rise, those investors became concerned that the assets held by the SIVs would suffer big losses. So they decided to start putting their money elsewhere.

  That was a very bad result for the FDIC, because as funding for those assets started to dry up, Citi and others were forced51 to consolidate SIV mortgage assets onto their balance sheets, where they could be backed by more stable insured deposits. Consolidation exposed the banks and bank holding companies to losses on those assets, even though they had not held capital and reserves against this risk because the assets were held off balance sheet. The use of the SIV funding structure was one of many instances of unbelievable Citi mismanagement we were only beginning to understand and that would later lead to the need for three bailouts of that bank.

  The next clue came on Friday, March 14, 2008, when I received an early-morning call from one of our senior examiners advising me that Bear Stearns would be declaring bankruptcy that day. “Investment banks fail,” I told him and went back to sleep for another precious thirty minutes before getting up to go to work.

  But when I got to the office, I was given a different narrative. Now I was hearing that JPMorgan Chase was going to buy Bear Stearns for about $2 a share in a government-assisted transaction. The New York Federal Reserve Bank, led by Tim Geithner, would assume the risk of loss on about $30 billion in high-risk mortgage securities held by Bear. I was g
etting most of my information from CNBC. No one from the Fed or Treasury was talking to me. However, at the time, I did not think that was remarkable, given the fact that Bear Stearns was an investment bank, which we did not insure and for which we had no responsibility.

  What I did think was remarkable was why the NY Fed was even getting involved. Among the five major securities firms, Bear was the smallest. It was one of the weaker firms that had fed on the subprime mortgage craze in the extreme. Why didn’t the NY Fed just let it go down? I was also incredulous that the NY Fed was claiming that it had legal authority to step in and support the merger, which would protect all of Bear’s counterparties and bondholders. The FDIC was the only agency that had the authority to resolve failing financial institutions, and that authority was limited to banks, which we insured, not securities firms, which were outside the safety net of deposit insurance and Fed discount window lending. In the past, when securities firms had gotten into trouble, they had been acquired or recapitalized by private-sector entities, or they were placed into bankruptcy. Yet here the NY Fed was, putting government money at risk to protect Bear’s counterparties and creditors; even Bear’s shareholders would get a little something out of the deal.

  It was all the more amazing given the fact that the FDIC was strictly prohibited from providing government assistance to keep a failing institution open. Under our rules, if a bank failed, it was put into our resolution process, which, like bankruptcy, imposed losses on shareholders and creditors. If we wanted to “bail out” an institution, that is, provide government money to keep it open and protect its stakeholders from loss, we had to invoke something called the “systemic risk” exception. That was an extraordinary procedure whereby supermajorities of the FDIC board and the Federal Reserve Board had to certify that putting a bank into our bankruptcy-like resolution process would cause “systemic” ramifications—that is, resolution would result in broad, adverse consequences for the larger economy. Once the FDIC and Fed boards made that determination, we had to seek approval by the Treasury secretary and the concurrence of the president himself. It was an extraordinary process, as was appropriate. Protecting a mismanaged financial institution and its stakeholders from the consequences of their own actions with government money was, needless to say, a step that should rarely, if ever, be taken. In fact, prior to the 2008 financial crisis, the FDIC had never invoked the systemic risk exception. But here we had the NY Fed going out on its own and deciding to bail out a relatively small investment bank, a perimeter player at best. It was very curious to me, and I was concerned about the precedent the NY Fed was setting. But I had no jurisdiction to object, and at that point I had other, more pressing matters to worry about.

  Insured banks and thrifts with large exposures to subprime and nontraditional mortgages were starting to deteriorate markedly. On March 26, 2008, I convened a meeting with the heads of the other banking agencies to review our staff’s analysis of insured banks and thrifts with more than $10 billion in assets that we believed were at heightened risk of failure. There were thirteen such institutions52, with the biggest threats being WaMu, with $300 billion in assets and $190 billion in insured deposits; National City (NatCity), with $138 billion in assets and $92 billion in insured deposits; and IndyMac Bank, with $32 billion in assets and $18 billion in insured deposits. Our staff projected that IndyMac would fail by the fourth quarter of 2008 and that the rest of the thirteen institutions were at heightened risk of failure. We asked the other regulators to intensify their supervision of these institutions and to have them increase their capital base. Most important, we asked that they make sure that insured deposits were not being used to fund high-risk mortgages previously funded through the securitization market, which, by that point, had completely dried up.

  At the top of our worry list was WaMu, a $300 billion Seattle-based mortgage lender regulated by the Office of Thrift Supervision, given its size and fragile condition. Fortunately, in January 2008, Bank of America had already announced plans to acquire another troubled West Coast thrift, Countrywide. Contrary to popular belief, we played no role whatsoever in BofA’s acquisition of Countrywide, and although I was relieved that a larger, more profitable commercial bank had taken it over, I was very concerned that the purchase price had been too high. Another national bank, Wachovia, had purchased a large California thrift, Golden West, at the top of the market in May 2006, and the losses associated with that pricey acquisition were already starting to weigh on Wachovia’s balance sheet—indeed, it had experienced a 98 percent drop in earnings in the fourth quarter of 2007, and its stock price was down by more than 40 percent. But in early 2008, at least, it appeared that BofA could handle Countrywide’s troubled-mortgage portfolio and that although Wachovia would suffer significant lost earnings from its acquisition, its solvency would not be threatened.

  WaMu, on the other hand, was a completely different kettle of fish. If pride goeth before a fall, WaMu’s management stood as a case in point. The thrift had grown rapidly from a smaller regional mortgage lender into one of the country’s largest thrift institutions, with branches scattered throughout the country and a heavy exposure to California’s overheated housing market. WaMu’s management was viewed by many in the market as unsophisticated and not up to the task of managing an institution of that size. The bank had long been viewed as a takeover target, but its management had persistently fended off potential suitors, determined to maintain both their jobs and their autonomy. And notwithstanding the institution’s rapidly rising delinquencies and charge-offs on its troubled-mortgage portfolio, management refused to see the necessity of finding a larger, healthier partner to help it ride out the storm, as the more savvy executives at Golden West and Countrywide had done.

  The other problem with WaMu was its too-close relationship with its primary regulator, the OTS. Having lost two of its three major charters (Countrywide and Golden West) to national banks that were regulated by the OCC, I feared that OTS would work to prevent an acquisition of WaMu to preserve its one remaining major charter. Those fears were confirmed when we were alerted by JPMorgan Chase that WaMu CEO Kerry Killinger had refused to talk with it about a possible acquisition because of JPMorgan’s (understandable) desire to conduct due diligence on WaMu’s loan portfolio before making an offer. That was outrageous. WaMu could not afford to be picky any longer. Its fourth-quarter loss of $1.9 billion had surprised analysts. Its stock price was down by 67 percent, and though its credit rating was still investment grade, it had been subject to a series of downgrades by all the major ratings agencies. The local press in Seattle53 was running stories trying to reassure depositors about the safety of WaMu’s FDIC-insured deposits. And as if its mortgage problems weren’t enough, its credit card losses were among the highest in the industry.

  Where had WaMu gone wrong? Its problems had begun in 2005, when it had shifted its mortgage business away from traditional fixed-rate loans to subprime loans and option ARMs to compete with Countrywide. Internal memos written by WaMu officials in 2006 estimated that profit margins on subprime loans and option ARMs were six to ten times as profitable as traditional mortgage products. To ramp up the volume even further, WaMu had originated a significant number of “stated income” or “low-doc” loans that allowed borrowers to simply write in their income on the loan application without independent verification. About 90 percent54 of WaMu home equity loans, 73 percent of its option ARMs, and half of its subprime loans were low-doc mortgages. Our examiners feared that those toxic loans would ultimately generate tens of billions of dollars’ worth of losses for WaMu, far exceeding its capital base.

  I contacted OTS head John Reich to determine the basis of JPMorgan Chase’s complaints and let him know that we had been told that it was going to pull out of discussions if it could not conduct additional due diligence. I also made clear our view that an acquisition by a healthy bank, as opposed to an additional capital investment by private-equity investors, would likely provide a permanent solution to WaMu’s pr
oblems. An additional capital infusion might or might not be sufficient to keep WaMu solvent, given the uncertainty about the scope of its losses. I was particularly concerned that Killinger, given his desire to maintain control over his institution, would skew his presentation of options to the WaMu board toward a private-equity group, TPG Capital, led by David Bonderman, who was close to Killinger and had served on the WaMu board in the past. From the standpoint of the shareholders, it seemed clear to me that an acquisition by Chase was the better course. Shareholders would not have to accept dilution, as they would with the TPG proposal, and it would remove any risk of a WaMu failure. At that time, Chase was probably the strongest bank in the world. In my email, I told Reich:

  This is something55 the WaMu board and ultimately the shareholders need to decide, with input from their regulators on prudential considerations associated with the various options. I think the discussion yesterday emphasized the advantages of an acquisition in assuring adequate infusions of capital on a long-term basis, as well as the stabilizing impact it could have on market perceptions of WaMu. As WaMu’s insurer and backup regulator, I look to you as their primary regulator for help in assuring that WaMu will fully and fairly present all options to its board and that OTS will evaluate all options with the management and board from a safety and soundness standpoint.