Stress Test

  So most toxic assets remained on the balance sheets of banks, burning holes in their capital, unsettling investors. In four months, Citi lost half its market capitalization. And plenty of institutions were in worse shape than Citi.

  BY DECEMBER 2007, market conditions were deteriorating again. Credit spreads were widening, and liquidity was draining away. Real estate was still in a tailspin, with foreclosures nearly double from the previous year. The credit crunch and the housing mess were also leaking into the larger economy, with unemployment rising to 5 percent; the National Bureau of Economic Research would later peg the start of the Great Recession to that month.

  Ben, Don, and I decided to move on two fronts: another interest rate reduction and a new liquidity program. We hoped the combination of the two tools would increase their power.

  Ben’s inclination was to cut rates another half point. But Thomas Hoenig of Kansas City had dissented from the last quarter-point cut, and the FOMC’s tight-money wing still thought inflation was a serious risk. Unlike Greenspan, who expected the Fed to follow his lead, Ben’s instincts ran toward deference and consensus building. He wanted to chart a course acceptable to the hawks as well as doves such as Janet Yellen of San Francisco and Eric Rosengren of Boston. So we compromised on another quarter-point rate cut. This time, Rosengren dissented, saying the cut should have been bigger, and apparently many investors agreed. Stocks fell sharply.

  The next day, we announced the Term Auction Facility, the first of many novel efforts by the Fed to unclog the pipes of the credit system. The TAF made four-week Fed loans available to the thousands of banks with discount window access, through an auction process designed to avoid the stigma of the window. We also put in place large foreign exchange swap lines with the ECB and other central banks, so they could make dollars available to their own banks, a dramatic expansion of a traditional central bank instrument. Within a year, we would be lending five times as much through the TAF as the discount window. And we would have over half a trillion dollars in outstanding swaps, a lifeline for overextended foreign banks that had borrowed in dollars to buy U.S. mortgage assets. The Fed would become the world’s lender of last resort.

  At the time, though, our initiatives did not provide the reassurance we had hoped. We had separated our announcements of the rate cut and the liquidity programs by a day, because our European counterparts didn’t want to get caught up in a U.S. monetary policy action, but markets were so disappointed by the rate cut that the liquidity programs seemed anticlimactic. Rubin told me that markets thought that the Fed was behind the curve, that we didn’t realize how bad it was out there. Larry needled me about our Vietnam approach, mocking our incremental efforts to whittle away the crisis with underwhelming force.

  We were still feeling our way, taking tentative steps. The TAF was innovative and the swap lines were helpful, especially for European banks that needed dollars, but they weren’t going to reduce the losses on mortgages, fill the capital holes of troubled firms, or provide liquidity to the investment banks and other U.S. nonbanks that needed it most. It would have been nice if our commercial banks had used funds from the TAF to lend to more troubled institutions or buy up their toxic assets, but the psychology of the markets had shifted toward caution, and few bankers were in a lending or buying mood.

  The day after we announced the TAF, I delivered welcoming remarks at the second annual New York Fed—Princeton University conference on, coincidentally, liquidity. “Your timing is good,” I told the group. “Perhaps too good.”

  In my usual stilted Fed-speak, I painted a dark picture of investors fleeing to safety, banks hoarding liquidity, and creditors mistrusting counterparties. “The danger this poses,” I said, “is the risk of an adverse, self-reinforcing dynamic”—in other words, a vicious cycle, a doom loop. Really, we had already fallen into that dynamic, and we hadn’t figured out a way to reverse it, or even to slow it down.

  BY CHRISTMAS, I felt bone tired and numb. My family and I used airline miles to visit Bali, but even Bali didn’t offer much of an escape. It was the rainy season. We all got sick. And the island was a much busier place than the rustic paradise I had visited in high school. I read War and Peace, which was therapeutic, but its tragic themes of human failure were not uplifting. I spent most of our days in Indonesia worrying that our rate cuts and our liquidity tools weren’t getting much traction.

  Chairman Bernanke was usually a calm and conciliatory presence, but on a call in early January 2008, he sounded worried, too, and frustrated by the constraints of consensus on the FOMC. Ben told me he no longer intended to be so deferential to the FOMC’s hawks. If they wanted the Fed to stand around inert as the crisis intensified, they could dissent. He wouldn’t meet them halfway anymore.

  “If I’m going to be hung, I want to be hung for my own judgments,” he said. “Not theirs.”

  I was delighted to hear that. If we wanted to do the right thing for the economy, we couldn’t keep placating the hawks for the sake of consensus.

  Unfortunately, our first move after Ben’s shift into assertive mode didn’t go as well as we hoped. Ben had signaled in a speech that a rate cut was coming at our next meeting, but on Martin Luther King, Jr., Day, when a sell-off shook global markets while U.S. exchanges were closed, we decided not to wait. We reduced rates by three-quarters of a point, the largest cut since 1982 and the first cut between meetings since the September 11 attacks. We only learned the next day that the sell-off was mostly driven by a French bank trying to unwind the positions of a rogue trader, not a new wave of concerns about global growth. We were accused of being clueless and trigger-happy, of trying to boost asset prices and rescue speculators instead of focusing on macroeconomic fundamentals. We cut rates another half point at our next formal meeting, to 3 percent, prompting more howls of protest that we were reinstating the Greenspan Put. Fisher dissented, saying we shouldn’t have cut rates at all, continuing to see inflation around every corner.

  It looked like we were lurching. When it came to the expectations game of monetary policy, I often talked about how important it was to get the theater right as well as the substance. The general view was that we had botched the theater, undermining our substance. At the annual economic forum in Davos, Switzerland, in January, the buzz in the hallways was that the Fed had overreacted and made things look worse than they were, undermining confidence.

  I thought our critics were too complacent. At one roundtable, I made the case to a group of central bankers that included the ECB’s Jean-Claude Trichet and his future successor, Mario Draghi, that the balance of risks had shifted dramatically toward economic weakness and financial distress.

  “In these circumstances, you don’t have perfect foresight,” I said. “You’re going to make mistakes, and you’ve got to decide which kind of mistakes are less damaging.”

  It would be easier to correct the mistake of doing too much, I argued, than to escalate too slowly, let the situation burn out of control, and have to correct the mistake of doing too little. It made more sense to err on the side of averting a financial meltdown, to buy insurance against a macroeconomic disaster.

  Much of the Davos crowd thought we were feckless. First we had rattled the markets by underreacting, then we had rattled the markets by overreacting. But a panic tends to make everyone look feckless, in the same way a mania makes everyone look brilliant. I remember arguing with Larry in the lobby of the Belvédère hotel about some harsh words he’d said and written about Ben and Hank. I was probably overprotective of my colleagues in the foxhole—and overly defensive about my own role—but I told Larry that it was bad form for a former Treasury secretary to second-guess a successor in public, and that not even he could imagine the constraints Ben and Hank faced.

  “You have no idea how hard this is,” I said.

  I TRAVELED with my family to California in February to look at colleges for my daughter, Elise, but again, I wasn’t really with them. We stayed with my former Treasury colleague Sheryl Sa
ndberg, who was especially close with Elise, but I spent most of the time on my cell phone. We also spent a few days at Big Sur, staying at a hotel that had yurts overlooking the ocean. This time, I spent most of the time on a satellite phone; I had to drive to the edge of a cliff just to get a signal, and spent hours in a light rain on call after call. I remember hearing two of my board members, Dick Fuld of Lehman Brothers and the developer Jerry Speyer, describe the carnage in the real estate markets with a new level of concern in their voices. There was more fear, more urgency, more direct appeals for the Fed to do more.

  Every morning, the New York Fed’s market room sent around a dashboard of about fifty economic and financial indicators. Most were heading the wrong way. Mortgage-backed securities were still bleeding. Rating agencies were belatedly downgrading them, leading to margin calls, forced asset sales, and more bleeding. Prices for credit default swaps—derivative contracts insuring against the failure of a firm or default of a security—were rising. Ambac, MBIA, and other large monoline insurers that stood behind many mortgage securities faced downgrades as well; even the dull municipal bonds they backed were starting to wobble. The New York state insurance commissioner, Eric Dinallo, had tracked me down in Davos, frantically informing me that the monolines were in trouble and that Charlie Gasparino was criticizing him on CNBC for not doing something about it. I didn’t know who Gasparino was—I didn’t watch much TV—but in any case I told Dinallo the Fed couldn’t help mortgage insurers.

  I would later be criticized as a walking source of moral hazard, too willing to provide financial assistance, but to many firms and investors caught up in the early phase of the crisis, we were not nearly generous enough. I routinely rejected requests for public support of private institutions. John Snow, Hank’s predecessor at Treasury, once came to see me with the CEO of the private equity firm Cerberus. The CEO explained they were patriots who had tried to help America by investing in Chrysler and GMAC, the troubled financing arm of General Motors; now they wanted the Fed to help them. My staff and I were darkly amused by the idea that these investments had been acts of patriotism. But we got many similar requests for assistance, though I don’t remember anyone else invoking the patriot defense.

  In fact, there’s nothing wrong with letting a crisis burn for a while, as long as you have the ability to contain it before it rages out of control. Just as a modest wildfire can get rid of some underbrush and improve the health of a forest, a modest crisis can clear out dry tinder in the system and make the financial system more resilient. But I was growing increasingly pessimistic that we had the authority or the firefighting tools to contain this one. The fire wasn’t responding to some pretty aggressive monetary easing and a pretty forceful provision of liquidity to banks. The markets were looking to us for more powerful solutions, but I didn’t think our options were that powerful. That feeling of responsibility combined with helplessness, the inability to alter the path of events, ate away at me.

  The most flammable parts of the system were the institutions reliant on tri-party repo and other short-term financing markets, where some creditors were flatly refusing to accept mortgage securities that didn’t have Fannie or Freddie behind them, while the rest were demanding more collateral. Institutions loaded with these “non-agency” securities now struggled to finance them. For example, the investment bank Bear Stearns had to ratchet up its reliance on tri-party repo in 2007 after creditors stopped rolling over its commercial paper; now a sizable chunk of the collateral behind its repo book was in illiquid assets, and it wasn’t clear how long its lenders would accept them. In early March, margin calls led to fire-sale liquidations of several major investment funds, including one owned by the vaunted Carlyle Group, and the cost of insuring against a default by Bear nearly doubled in a week. We were slipping into a more dangerous phase of the deleveraging spiral.

  My staff had been working for months on an innovative new program, the Term Securities Lending Facility, designed to provide some relief where it would do the most good. The TSLF would allow the twenty “primary dealers,” including the five large stand-alone investment banks, to borrow Treasuries from the Fed against an unprecedented range of collateral, including the AAA-rated non-agency securities that the private sector would no longer finance. We hoped to thaw the frozen markets for those securities, since they would now be exchangeable for Treasuries. We also hoped to ease liquidity pressures throughout the system, reaching beyond commercial banks for the first time to the most troubled part of the markets.

  This required us to invoke the Fed’s emergency powers, the “unusual and exigent” language of Section 13(3). Kevin Warsh, a well-connected Republican who advised Ben about politics as well as finance, suggested that accepting collateral nobody else wanted could expose the Fed to potential criticism as well as losses. But Ben didn’t flinch. On Sunday, March 9, 2008, he emailed the members of the Fed board to rally their support for this bold step.

  “This is unusual, but so are market conditions,” he wrote. “I strongly recommend that we proceed with this plan.”

  On Monday, the Fed approved the TSLF. Unfortunately, the $200 billion program wouldn’t be ready for two weeks. By then, the circumstances would be even more unusual and exigent.

  “I THINK I’ve been around long enough to know a serious problem, and this seems like one.”

  It was Wednesday night, March 12, and Rodgin Cohen was on the phone. Rodge was the lawyer to see for financial institutions with problems, a legendary fixer known as “Wall Street’s trauma surgeon.” I spoke to him all the time, because he seemed to represent everyone in town—including Lehman Brothers, Fannie Mae, AIG, and just about every other firm that got in trouble during the crisis—and he always had something thoughtful to convey about what was going on. This time, he was calling on behalf of Bear Stearns and its CEO, Alan Schwartz. “They’re really worried,” Rodge said. After Moody’s downgraded some mortgage securities Bear had issued, markets had started running from the eighty-four-year-old investment bank. Rodge wondered if we could speed up the TSLF launch so that Bear could swap some illiquid assets for Treasuries. Then its skittish repo lenders might be more willing to extend it credit.

  “If Alan is worried, he should call me,” I said. I didn’t think we could help, but I wanted to hear his voice, and get a better feel for how bad things really were.

  Bear had survived the crash of 1929 without shedding a single employee, but ever since subprime mortgages sank its memorably named Enhanced Leverage Fund in the summer of 2007, markets had viewed it with suspicion bordering on disdain. It was the smallest and most leveraged of the five major investment banks, with $400 billion in assets and $33 in borrowing for every dollar of capital. It was seen as Wall Street’s weakest link, badly managed, disproportionately exposed to mortgages. For months, its lenders had been demanding more collateral. Bear’s previous CEO, Jimmy Cayne, had been forced out in January as its losses piled up.

  The SEC, Bear’s regulator, had never expressed much concern about its condition, at least not to us. The SEC’s core mandate was to go after market manipulation, fraud, and insider trading; they didn’t focus much on financial stability. As late as that Wednesday, SEC staffers were still assuring us Bear had plenty of liquidity. And SEC Chairman Christopher Cox told reporters his agency had “a good deal of comfort” with Bear’s capital cushion.

  Schwartz had gone on CNBC at 9 a.m. to try to beat back rumors that Wall Street no longer wanted to do business with his firm. “None of those speculations are true,” he said. But as Bagehot knew, a banker forced to defend his credit has already lost it—and the speculations were in fact true. Hedge funds were closing out brokerage accounts with Bear. Derivatives counterparties were “stepping out” of existing trades and rejecting new ones to avoid exposure to Bear. CNBC interrupted the interview with the news that New York Governor Eliot Spitzer was resigning amid a prostitution scandal, but that bizarre interlude didn’t stop Schwartz from complaining, accurately if not wisely, t
hat investors were choosing to “sell first and ask questions later … which creates its own momentum.” Bear’s liquid reserves had dropped from $18 billion to $12 billion in two days. This felt much darker than the Countrywide scare, because Bear seemed more systemic, and the broader financial world was in a much more fragile place.

  The run became a sprint on Thursday, leaving Bear with just $2 billion in cash at the end of the day. The markets had lost all confidence in Bear. Some of its repo lenders were preparing to stop rolling over its loans on Friday, including loans with safe Treasuries as collateral. Around 7:30 p.m., when I had just gotten home, Schwartz called to let me know that Bear planned to file for bankruptcy in the morning. Yikes! I convened a call with the Fed and the SEC. The SEC officials said they saw no way to avert a filing, then outlined the limited steps they expected to take to protect the brokerage accounts of Bear’s customers.

  “OK, we’re going home,” the senior SEC official on the call finally concluded. “We’ll talk in the morning.”

  Really? With a $400 billion investment bank about to default on its obligations, it seemed a bit early to call it a night. Nothing is more dangerous during a panic than the sudden liquidation of a major institution, so I asked my chief of staff to call our people back into the office. Even if we couldn’t prevent an ugly crash, I wanted to explore ways to put “foam on the runway”—anything to mitigate the damage.