Crashed

by Adam Tooze

  I

  One option was nationalization. That is what the British had been forced to do to Lloyds-HBOS and RBS. Germany’s Commerz and Hypo banks were in state hands. Economists pointed out the positive example of Sweden, which when faced with a major banking crisis in the 1990s had taken radical action. After nationalizing and restructuring its banks the economy had bounced back fast. By contrast, Japan had put off restructuring and recapitalizing its banks and had languished ever since. Perhaps the solution was to follow the Swedish example, to break up America’s megabanks, restructure, recapitalize and then return them to the market. What would once have been dismissed as Luddite was now merely common sense. In February 2009, former Fed chair Alan Greenspan, who as a young man had sat at the feet of free-market goddess Ayn Rand, told the Financial Times: “It may be necessary to temporarily nationalise some banks in order to facilitate a swift and orderly restructuring. . . . I understand that once in a hundred years this is what you do.”8 On network TV news, the Republican senator for South Carolina Lindsey Graham opined that “[t]his idea of nationalizing banks is not comfortable . . . [b]ut I think we’ve got so many toxic assets spread throughout the banking and financial community, throughout the world, that we’re going to have to do something that no one ever envisioned a year ago, no one likes.”9

  The intensity of feeling running against the banks in early 2009 was such that President Obama had to take a stance. At a press conference on February 10, 2009, he took up the international examples that everyone was talking about. He acknowledged the off-putting experience of Japan in the 1990s with its botched bailout and recognized that Sweden had done far better after nationalizing its banks. “So,” Obama continued, “you’d think looking at it, Sweden looks like a good model.” But the president was never comfortable with the comparison: “Here’s the problem,” Obama remarked. “Sweden had like five banks [laughs]. We’ve got thousands of banks. You know, the scale of the US economy and the capital markets are so vast. . . . Our assessment was that it wouldn’t make sense. And we also have different traditions in this country. . . . Obviously, Sweden has a different set of cultures in terms of how the government relates to markets and America’s different. And we want to retain a strong sense of that private capital fulfilling the core—core investment needs of this country. And so, what we’ve tried to do is to apply some of the tough love that’s going to be necessary, but do it in a way that’s also recognizing we’ve got big private capital markets and ultimately that’s going to be the key to getting credit flowing again.”10

  It was not Obama at his most articulate. But it was a clear statement of basic principles. The “core investment needs of the country” were a matter for “private capital.” Government stimulus spending, whether on infrastructure or on education, was incidental. What was crucial was getting the banks back on their feet. It was music to the ears of the man who would deliver the “tough love” that Obama promised—Tim Geithner, his Treasury secretary. For Geithner nationalization was never an option. In 2008 at the New York Fed he had seen the depth of the market panic. He had witnessed the ructions over Bear and Fannie Mae and Freddie Mac. He had been in the room on the afternoon of Monday, October 13, alongside Paulson, Bernanke and Bair when they forced the bankers to take TARP capital. That was enough. As far as Geithner was concerned, to have pushed for further nationalizations in 2009 would have been a “deeply transforming policy mistake.”11

  Despite the united front against the Swedish option that Obama and Geithner presented, given boiling public resentment and the drip of scandalous revelations about the bailouts, the way ahead was far from obvious. Larry Summers and Christina Romer, the leading economists in the administration, were compelled by the Swedish example, as was Paul Volcker. Perhaps a short, sharp restructuring under state ownership was what America’s financial system needed. So intense did the debate become that on the afternoon of March 15, 2008, a summit was convened in the White House to clear the air.12 With the president looking on, the argument swayed back and forth for several hours before Obama impatiently declared that he had other business to attend to and he expected a conclusion by the end of the night. After the president left the room the issue was decided by his foul-mouthed chief of staff, Rahm Emanuel. If bank restructuring and comprehensive recapitalization along Swedish lines would cost upward of $700 billion, it was not going to “f***ing happen.” After TARP and the stimulus, with health reform in the pipeline, Emanuel could not ask the centrist Democrats in the House to back more spending. The economists would have to come up with another plan.

  By 2009 the problem was no longer the investment banks. They were back in profit. The problem was the ailing commercial banks. Citi was the worst. So rather than a comprehensive restructuring of the entire American banking system, the meeting agreed that the remaining TARP funds should be concentrated on backstopping a “resolution” of Citigroup. This gigantic, oversized monolith should be broken up, downsized, restructured and the worst assets hived off to a bad bank. Without alerting Sheila Bair of the FDIC to the intensity of the debate going on inside the administration, Summers had sounded out with her the possibility of creating an $800 billion bad bank for Citi’s worst assets and bailing in its shareholders.13 The Citi plan was approved by Obama later that evening. The Treasury was charged with working out the details. It ought to have been momentous. Citigroup was huge. Back in 1998 its merger with Travelers Group had sounded the death knell of the old days of “boring” high street banking. By way of Rubin, it was tightly politically connected to the Democratic Party. And the pressure for action was only increased the following day, when the scandal erupted over bonuses paid to AIG’s senior staff. The president was furious. He wanted action. The nation’s top thirteen bank bosses were summoned to a meeting in the White House.14

  At this moment there was a real fear on Wall Street that the Obama administration was about to go to war. Given how unpopular the banks were, it would have made good politics. But it didn’t happen. Despite the decision endorsed by the president on March 15, Geithner never agreed with restructuring Citigroup. No one had ever unraveled a bank of Citigroup’s complexity. It was not clear that the Treasury had the resources and legal authority to carry it through. A protracted restructuring would spook the markets. In the words of a later postmortem compiled by one of Obama’s closest advisers, the Treasury “slow walked” the Citigroup proposal.15 Though this delaying action bordered on insubordination, Obama showed little inclination to impose his will. As his remarks about the “Swedish case” had suggested, he was far from being a radical on banking issues. When Obama confronted the bank CEOs on March 27 the atmosphere was frosty. But he had summoned them to Washington not to punish them but to remonstrate with them. He appealed to the bankers to show restraint in their compensation and bonuses. “Help me help you,” the president pleaded. When several of the CEOs offered the customary justifications for their exorbitant compensation—their businesses were large and risky; they were competing in an international talent pool—the president interrupted in exasperation: “Be careful how you make those statements, gentlemen. The public isn’t buying that. . . . My administration is the only thing between you and the pitchforks.”16

  In the spring of 2009, rather than going over to the offensive, Obama and Geithner positioned themselves as the last line of defense for America’s financial system. It was their self-appointed mission to calm “the mob.” Of course, playing the good cop is a tried-and-tested negotiating tactic. But it is usually combined with stiff demands. Someone has to play bad cop. What was remarkable in 2009 was how little the Obama administration asked in return for the protection it offered. To the amazement of the hardened Wall Street deal makers, the only item on the table on March 27 was voluntary restraint on compensation. That was even less than Paulson had asked for six months earlier when he foisted TARP on them. In truth, if there were pitchforks being wielded by anyone in the spring of 2009, it was not by the Left agai
nst the banks but by the right-wing populists. With the lavish attention of Fox News and subsidies from friendly oligarchs, they were organizing themselves in the Tea Party movement. The target of their anger was not Wall Street but the liberals in the White House. The uncomfortable truth was that the Obamians lacked pitchforks of their own. Reviled by the Right and suspected by the Left of being in the pocket of Wall Street, as Geithner himself admitted, the administration would find itself in political “no-man’s land.”17

  In his early days as Treasury secretary, Geithner was quite commonly described as being formerly of Goldman Sachs.18 Given the precedent set by Paulson and Rubin, it was only to be expected. Geithner looked the part. He had the precocious youthfulness and pugnacity of a hotshot investment banker. The diary log of the New York Fed revealed that during his time there, Geithner regularly socialized with Citigroup executives, where his mentor Robert Rubin held court.19 And as Treasury secretary, Geithner continued those habits.20 But for all his cultivation of Wall Street, Geithner was until 2013 a career public servant, and a proud one at that. In his self-portrayal Geithner was not a banker but a soldier, a man of fortitude, serving in the interest of the national economy and the American people, willing to take upon himself the moral burden of dirty hands, to do what was necessary in the public interest. But how did Geithner define that public interest? First and foremost his commitment was to upholding the stability of “the financial system,” because without that, the entire economy was bound to fail.21 That was his key article of faith. The interests of America and the financial system were aligned. To explain his actions we do not need to imagine that he was in the pocket of any particular bank. It was his commitment to the system that dictated that Citigroup should not be broken up. Even more important, the key institutions of financial regulation and government must be protected too. When Geithner resisted bank nationalization it was to shield the monetary authorities as much as any individual bank. A comprehensive attack on Wall Street could all too easily spill over into an attack on the agencies that oversaw its business. In 2009 “audit the Fed” was a battle cry on both left and right.

  With Geithner at the helm, the Treasury’s response to the crisis was not to tackle “too big to fail” by breaking up the biggest banks. Nor was it to bring the interests of wider society to bear by way of politicized oversight. Instead, the Treasury’s solution was to increase the oversight and managerial capacities of the state’s regulatory agencies—the Treasury itself, the key regulators and the Fed. If capitalist finance was a given, then one would have to accept the necessity of dealing with gigantic banks and complex, fast-moving markets. One had to accept also that this system was crisis prone. Crises, indeed, were inevitable. All one could hope to do was to build a crisis-fighting capacity at the national and international levels that was adequate to cope. In 2008 the Fed and the Treasury had acted on a spectacular scale with effects well beyond the boundaries of the American national economy. At the London G20 the IMF had been given the firepower it needed. What the Treasury aimed to do in 2009 was to continue the consolidation at the national level. As it had done since October 2008, this would revolve around recapitalization. As they recovered from the shock the banks were champing at the bit to repay the TARP funds. To further force the pace the Fed and the Treasury cooperated to introduce a new regime of regulation and oversight known as stress testing. This would be followed by a major political effort to get legislation through Congress that would legitimize and regularize the business of overseeing financial stability. As the acute crisis of 2008 passed into memory, a new relationship between the big banks and the authorities would be given permanent shape.

  II

  Purely for internal purposes, the New York Fed had for some time been in the habit of conducting crisis simulations with the main banks on Wall Street.22 In February 2009, in his first major speech as Treasury secretary, Geithner announced that these so-called stress tests would be turned into a comprehensive exercise of public policy. The Fed and the Treasury would inspect and certify the soundness of every major bank operating in America. To do so, all the largest US banks would submit their accounts for inspection. Fed and Treasury officials would then apply to that data a hypothetical scenario of financial disaster, estimating the losses the banks would suffer and the resources they would be able to mobilize to withstand the shock. Effectively, the Treasury and the Fed would make themselves into the credit-rating agencies in chief—the “United States of Moody’s”—official arbiters of private creditworthiness and guardians of confidence in America’s financial system.23 Those banks that were shown to be at risk would be mandated to raise additional capital. Those that could not do so in the private capital market would be required to take money from the TARP fund.

  In rejecting the Swedish option, President Obama had gestured to America’s “thousands of banks.” At the time the president spoke there were, in fact, 6,978 commercial banks operating in the United States. But those never mattered to Geithner or Bernanke. They were the province of the FDIC. What mattered for systemic stability were the nineteen major banks with assets in excess of $100 billion, c. $10 trillion in total. Subjecting those massively complex institutions to thorough scrutiny would have been a labor of Hercules. The stress tests were something more tactical and fast moving. In a crash effort, a scratch team of two hundred bank examiners, supervisors and analysts ran through the books.24 The disaster scenario they applied was far from apocalyptic. They assumed that GDP would fall by only 2–3 percent, unemployment would rise to 8.5 percent and house prices would fall by between 14 and 22 percent. That turned out to be optimistic. But even starting from those numbers and the default probabilities they implied was enough to generate sobering conclusions. On top of the losses of $350 billion already recognized by the spring of 2009, under the stress test scenario the banks might expect to suffer a further $600 billion in write-downs and charge-offs by the end of 2010. This, then, posed the truly critical question: How much capital would be required to make the banks safe and restore market confidence? This was a matter of judgment. The Treasury and the Fed weighed a range of options from as little as $35 billion to as much as $175 billion. The risk, if they announced a huge capital shortfall, was that it might shake confidence irreversibly. On the other hand, if they announced a figure that was too low, it would undermine confidence in the stress-testing exercise.25

  According to inside reports, the original estimates caused consternation in banking circles. Bank of America faced a call for $50 billion in extra capital. Citigroup was called on to raise $35 billion. Wells Fargo was so dismayed at the initial ask of $17 billion that it threatened a lawsuit. In the end they settled on a bargained compromise. By far the biggest burden was imposed on Bank of America, which was required to raise $33.9 billion to exit the emergency ward. Wells Fargo’s quota was set at $13.7 billion. As its senior financial officer commented: “In the end we agreed with the number. We didn’t necessarily like the number.”26 Ailing Citigroup had more reason to be satisfied. By allowing for future revenue streams, its capital requirement was massaged down to a modest $5.5 billion, a seventh of the original figure.27 It was barely more than the bank would pay out in bonuses that year. After weeks of haggling, on May 7, 2009, the public was informed that America’s big banks needed to raise a manageable total of $75 billion.

  The stress tests were a balancing act that began with an exercise in accounting precision and ended in a game of bargaining and confidence.28 Whether they were taken in or simply delighted to discover how helpful the Treasury and the Fed were being, the markets responded well. The spread between very safe AA corporate bonds and the price that banks paid to borrow on their Baa bond rating fell from 6 percent to 3 percent, reducing funding costs. The week following the release saw a sustained 10 percent rally in bank stocks, a high tide on which the strongest banks immediately raised $20 billion in additional capital. On June 19 the first nine banks repaid and exited the TARP program. Over the mont
hs that followed, the eight banks still in the program, including the giants Bank of America and Citigroup, used every trick in the accounting book and all the help the highly cooperative IRS, Fed and Treasury could provide to exit TARP.29 In an extraordinary two-week period in December 2009, Citigroup, Bank of America and Wells Fargo raced one another to raise a total of $49 billion in common equity. Bank of America’s offering of $19.3 billion was the largest offering of common stock in US history.30 They crowded the market and could probably have raised more capital at lower cost if they had stretched the issuance over several months. But the authorities were in a hurry to wind up TARP, and for the banks time was of the essence. The sooner they could repay the Treasury, the sooner they could escape the limits on compensation imposed on all TARP recipients, thus allowing them to retain and compete for talent. It was, as Bair ruefully remarked, “all about compensation.”31