Bull by the Horns

by Sheila Bair

  “What are you reading, Sheila?” came the president’s voice. I looked up and saw him standing in our staff area. Everyone straightened up, a few jealous glances casting my way. “It’s a book about risk,” I said and smiled—an apt topic and, thank goodness, a substantive book. What would he have thought if I had been reading a Stephanie Plum mystery novel? “Come on back,” he said with a big wave. I started to get up and plopped right back down, forgetting that I still had my seat belt on. I released the metal buckle, successfully rose from my seat on the second attempt, and followed him to his personal office, a spacious room near the front of the plane.

  We must have talked for a good twenty to thirty minutes. He wanted to hear about our work on loan modifications and my prognosis on the health of the banking system and the overall economy. We talked about credit availability and small businesses. He was certainly focused on all of the right issues, and I was impressed with his sincerity, the depth of knowledge reflected in his questions, and his obvious desire to learn about what was going on in the banking sector and housing market from the frontline vantage point of the FDIC. It was such a contrast from the conversations with his senior economic team, where the attitude was that they already had all the answers and were talking to us only because the president wanted them to.

  If his strategy was to motivate me to help him achieve his foreclosure prevention goals, it worked. As frustrated as I was with the arrogance of his economic advisers and their failure to even listen to any criticism of their programs’ fundamental design flaws, I decided to do everything I could to try to make the programs work. I spoke in favor of them and instructed our staff to provide whatever technical assistance the administration requested. Unfortunately, after the big announcement, program implementation went from bad to worse. The Treasury Department was paying much more attention to Fannie, Freddie, the OCC, and the Fed than it was to us. It kept making the program more, not less, complicated. Primarily at the behest of the OCC and GSEs, it imposed extensive documentation requirements on borrowers, requiring detailed reports on income as well as monthly bills and expenses and credit card and other debt obligations. And it would not give a borrower a permanent modification until all of those documents were in. What it was essentially requiring was that the servicers requalify the borrower as if a new loan were being made. That was exactly the loan-by-loan process we had tried to avoid at IndyMac. The loan had already been made. The borrower had already bought the house. New money was not being provided to the troubled borrower. It was already out the door. To require every borrower to essentially prove that he or she could qualify for a new loan was stupid—the loan had already been made. And given the huge number of loans that needed to be reworked, as well as the problem of ill-trained, understaffed servicers, the cumbersome process was doomed to failure.

  What’s more, it cheated borrowers. Because Treasury wanted to demonstrate quickly that huge numbers of borrowers were being modified, it let borrowers enter into “trial modifications” whereby they would start making reduced payments pending completion of all of their paperwork. But many of the borrowers could not provide all of the extensive documentation required by the program, so they would be put into foreclosure even though they had been making timely payments for months! At IndyMac, we used a streamlined approach. We relied principally on electronic confirmation of borrowers’ previous year’s tax return from the IRS. That could be supplemented with two pay stubs and the name and contact information of their employer, whom we called to verify their income. Based on that information, we would take their mortgage payment down to 31 percent of their documented income. Once they provided that information and the first month’s check, they had their loan modification. That was it. Treasury and others criticized the approach because we didn’t look at the borrowers’ entire debt load when making the modification. But in point of fact, it worked, and the modifications we did at IndyMac, lowering mortgage payments to 31 percent of income using this streamlined approach, have performed as well as if not better than HAMP loans.

  As we had predicted, the financial incentives were not enough. By the end of 2010, nearly two years into the program’s operation, only about 522,000 successful permanent modifications had been completed. The government had spent about $2 billion on the program. The number of proprietary modifications—those that banks and servicers had done on their own outside of the program—was four times as high. (Of course, many of these provided no meaningful payment relief.) In the spring of 201198, Tim finally publicly acknowledged that the HAMP financial incentives were not strong enough to achieve the program’s ambitious objectives but failed to announce any meaningful reforms to the program. And he essentially blamed the servicers for the program’s failures. At the same time, neither Treasury nor the big servicers’ primary regulator, the OCC, took any effective action to punish those servicers and make them hire enough staff and training to execute the program effectively.

  Treasury never implemented our insurance program, nor did it ever institute quarterly meetings to review the program’s process. Tim and Larry had gotten what they wanted: my public support. I doubt if they ever had any intention of following through on their promises. For the next two years, I stood by as they flailed around with a fundamentally flawed program. Occasionally, I would get bits of information from Mary Schapiro, who, as head of the SEC, served on the TARP oversight board. She would fill me in on the HAMP briefings it received from Treasury staff. “Loan restructuring isn’t the SEC’s expertise,” I remember her saying. “Why don’t they have you on this board?”

  It was a good question.

  In retrospect, it was apparent that Larry and Tim were determined to keep me out of the design and operation of any of the programs from the very beginning. As I learned years later, Larry had dismissed our program to the president in December 2008, even though he had led me on in discussions well into February. In January 2012, the White House released the economic transition memo that Summers had prepared for the new president on December 15, 2008. In that memo, Summers had recommended the Bush economists’ subsidy program, though he had failed to inform the president of where the proposal had come from and its pitfalls, which we had well documented, and had frankly misrepresented our program to the president in recommending against it by citing nonexistent “scary redefault numbers99 coming out of IndyMac.”

  HAMP was a program designed to look good in a press release, not to fix the housing market. Larry and Tim didn’t seem to care about the political beating the president took on the hundreds of billions of dollars thrown at the big-bank bailouts and AIG bonuses, but when it came to home owners, it was a very different story. I don’t think helping home owners was ever a priority for them.

  CHAPTER 14

  The $100 Billion Club

  The loan modification program was not the only new initiative to be undertaken by the young Obama administration. Secretary Geithner was trying to take bank bailouts to a whole new level.

  My assumption was that now that the system had stabilized—given the trillions of dollars we had collectively thrown at it—it was time to roll up our sleeves and do the hard work of cleaning up bank balance sheets. The best way to do that would be to set up a government facility to buy troubled assets at a discount from financial institutions, rework them, and sell them back to the private sector. That was essentially what the Resolution Trust Corporation had done successfully to clean up the mess from the savings and loan crisis. Similarly, during the Great Depression, the government had set up the Reconstruction Finance Corporation (RFC) and the Home Owners Loan Corporation to acquire and rework troubled mortgages and other distressed loans sitting on bank balance sheets.

  However, the New York Fed and Federal Reserve staff had another idea. They wanted to conduct “stress tests” on the nation’s biggest banks, harkening back to another initiative undertaken during the Great Depression, when President Roosevelt had ordered a “bank holiday”—a euphemism for closing all of the nation
’s banks to halt the deposit runs that were causing widespread bank failures. Government examiners entered each bank and conducted a thorough analysis of its books and records. Each bank that was determined to be solvent by the government examiners was allowed to reopen.

  The Fed’s proposal was somewhat different. All of the banks would remain open. Obviously, with the public maintaining confidence in the FDIC’s guarantee, there were no bank runs to stop. But the Fed’s examiners, assisted by the other bank regulators, would “stress” the balance sheet of banks larger than $100 billion to make sure they had enough capital to remain solvent and continue lending even if the economy deteriorated significantly. If the examiners determined that they needed more capital to survive a much more adverse economic environment, the banks would be forced to issue new common stock or take TARP government capital.

  As Fed staff presented the idea, it was obvious to me that they and the Treasury had already decided that they were going to do the stress tests, though in fairness, they did seek our input on how to construct them. My initial reaction to the idea was one of ambivalence. Many banks definitely needed to bolster their capital levels to continue lending in an economic downturn, but capital by itself—particularly if it was government capital—wouldn’t be enough to keep them lending in a severe recession. With hundreds of billions of dollars of toxic mortgage and other real estate assets sitting on their books—and substantial uncertainty about the amount of losses they would ultimately have to absorb given the rapidly deteriorating real estate market—previously profligate banks would be reluctant to lend while those assets still sat there rotting on their balance sheets. Just propping up banks with additional capital, without also making them get rid of their toxic assets and take their losses up front, did not work. Japan had used exactly that strategy during its banking crisis of the 1990s, and it is reeling from the consequences of its banks’ profligate lending with moribund economic growth to this day.

  However, trying to be a team player, I did feel that the stress tests might be a good start if we used them as a catalyst to get banks to clean up their balance sheets. The banks would be in a much better position to attract new investment capital if they first cleared their books of toxic loans. Why would anyone want to invest in Citigroup, for example, with well over half a trillion dollars’ worth of distressed loans and other investments sitting on its balance sheet? And even the Fed and the Treasury seemed to agree that the stress tests would be only part of a broader strategy to strengthen the financial sector. The goal was for the major banks to build “fortress balance sheets,” meaning that they would have enough capital to continue to lend even in a severe downturn. Everyone seemed to agree that we needed a way to deal effectively with troubled assets—the original goal of the TARP legislation.

  Everyone also seemed to agree on the type of facility that the government would use to buy the bad assets. At our suggestion, the plan was to use a combination of TARP capital and private capital to buy the bad assets, using a competitive auction process. Private investors would be responsible for managing the troubled assets, with the government sharing in any profits once they were reworked and sold off. Such public-private investment partnerships (PPIPs) had been used by the FDIC during the savings and loan crisis with good results, and we had already been working on a similar structure to deal with the loans we acquired from failed banks. Moreover, mainstream investors such as Warren Buffett and Bill Gates had expressed an interest in participating in the facilities, a huge plus. The last thing I wanted to do was set up a facility that only hedge funds and other Wall Street types would use.

  Early discussions on the stress tests were tense. We wanted a clear connection between the stress test results and requiring banks to sell their troubled assets into the PPIPs. We had to have a lever to force them to sell their bad assets. The banks did not want to face reality. They were carrying the assets at inflated values, and selling them at competitively set “real” market prices was not something they would want to do. We worked to develop effective ways to achieve market prices that would better reflect the intrinsic value of the assets rather than the unrealistically discounted values in the deleveraging market. However, at each discussion, Treasury seemed increasingly determined to undermine any approach that would lead to the banks cleaning up their balance sheets as a primary way of regaining market confidence. The Fed, Treasury, and OCC were clearly much less committed to forcing banks to sell bad loans and other investments.

  There was also disagreement over how severe the stress scenario should be. The Fed’s adverse scenario showed GDP growth slowing to a half a percentage point and unemployment rising to 10.3 percent in 2010. We viewed that scenario as a highly likely one, not an extreme stress environment. Our head of insurance and research, Art Murton, ran internal stress tests to determine how an extreme recession might impact bank failures and losses to the Deposit Insurance Fund. For that purpose, we assumed a 13 percent unemployment rate. (In fact, the unemployment rate peaked at 10.1 percent in October 2009.)

  There were even more disagreements about what we would do with the banks that failed the stress tests and needed more capital. The OCC and its general counsel, Julie Williams, questioned whether the regulators had the legal authority to require banks to maintain their capital above the regulatory minimums. I thought that was shortsighted and indicative of the narrow, pro–big bank focus of the OCC. Congress had given the banking regulators broad authority to define and enforce safe and sound banking practices. The banks needed to be prepared for a downturn and show that they could keep lending. The whole purpose of deposit insurance was to make sure that banks would have funds to keep lending. With deposit insurance and its tremendous government benefits, banks large and small had an obligation to support the credit needs of the real economy. The fact that the OCC would even question our authority to tell the banks to raise their capital cushions above the bare-bones regulatory minimums spoke volumes about that agency’s skewed priorities and inability to see beyond the needs of its largest banks. Bank regulators, including the OCC, routinely forced smaller banks to maintain capital ratios higher than the regulatory minimums.

  Tim was eager to announce the initiative. I was reluctant to go public with any such proposal until the details had been worked out, particularly on the PPIP. And I thought the markets would be surprised by the stress test announcement because they were expecting a troubled-asset program.

  But Tim was eager to move ahead. So on February 10, he held a major press conference to announce his Financial Stability Plan. The lead announcement was Treasury’s new Capital Assistance Program, under which the banking regulators would stress test the balance sheets of the nineteen bank holding companies with assets in excess of $100 billion and would be provided with additional TARP capital if the stress tests indicated that they needed it. Our PPIPs to buy troubled assets were given short shrift—two paragraphs in the announcement—but the Fed’s programs to buy mortgage-backed securities from banks were given prominence. At Tim’s insistence, we had agreed to extend the TLGP an additional four months, through October 2009, so that it would sync up with the expiration of some of the Fed’s emergency programs. The announcement also included somewhat stronger conditions on lending and executive compensation, including a prohibition on common stock dividend payments absent approval from the Treasury and the Fed.

  It was Tim’s first major news conference as Treasury secretary, and he was visibly nervous as he explained the program to a roomful of reporters. Notwithstanding our differences, I felt bad for him. The secretary of the Treasury needed to be a commanding figure, someone who exuded confidence and strong leadership. Tim had always played a staff role. Even as the head of the NY Fed, he had basically been the mechanic who had engineered the bailout programs. Hank and Ben treated him almost like staff. He had been elevated to the role for all of the wrong reasons, boosted by Bob Rubin, who no doubt had had every expectation that Tim would continue his Citigroup-friendly policies. Tha
t ill-fated choice was painfully apparent as he struggled to get the words out, his voice at times quivering, his eyes darting nervously back and forth across the room. He looked like a scared little boy.

  The market reaction was devastating. The Dow Jones Industrial Average100 sank nearly 382 points after the announcement. Tim’s rollout was universally criticized as lacking content and detail. Bank stocks were roiled. Ironically, Citi and other101 weak banks were hit the hardest as investors speculated over which banks would or would not pass the tests. Everyone assumed that Citi would be forced to raise significantly more capital, which would further reduce the value of its already decimated outstanding shares.

  With bank stocks under severe pressure, Tim decided that the banking regulators needed to issue a reassuring statement. So on February 23, we all joined in another statement that essentially said that the chosen nineteen would be propped up by the government no matter what: “[T]he capital needs102 of the major U.S. banking institutions will be evaluated under a more challenging economic environment. Should that assessment indicate that an additional capital buffer is warranted, institutions will have an opportunity to turn first to private sources of capital. Otherwise, the temporary capital buffer will be made available from the government.”

  Many traditionalists, including Warren Buffett, lashed out at the stress tests as wrong and unnecessary. He was quoted103 in the Financial Times complaining that Citigroup’s high-profile problems had tainted the entire industry. Most of the banking institutions were relatively healthy, he said, and in any event, fourteen of the nineteen banks being stress tested could easily be resolved under the FDIC’s normal processes if they got into trouble.