Stress Test

by Timothy F. Geithner

  “We’ve got to make it clear we’re standing behind Citi,” I said on a November 20 conference call with Hank, Ben, Sheila, and the OCC’s John Dugan.

  The next day, two hours after the news of my nomination leaked, Ben forwarded me a document titled “Potential Actions to Support or Resolve Citigroup,” which discussed possibilities such as receivership or bankruptcy. But we had no intention of letting that happen. The system couldn’t have handled the sudden collapse of a $2 trillion institution that provided much of the world’s financial plumbing. On a conference call Saturday morning, Hank nearly had a fit when Sheila suggested the FDIC could force Citi into receivership without melting down the system.

  “If Citi isn’t systemic, I don’t know what is!” he replied.

  Citi needed a solution that weekend, and because of my pending appointment, I decided to remove myself from the deliberations about what to do. The rescue package that the Treasury, the Fed, and the FDIC negotiated did what was needed to prevent disaster for the moment. It shored up Citi’s thin capital buffer, injecting another $20 billion from TARP while ensuring more upside for taxpayers. It also reduced Citi’s exposure to catastrophic tail risk by putting a government-backed ring fence around $306 billion of its assets. Citi would absorb the first $39.5 billion in losses on those assets, plus 10 percent of any losses above that, but Treasury would take the next $5 billion in the government’s portion of losses through TARP, the FDIC the next $10 billion after that, and the Fed would absorb the rest in a worst-case scenario.

  The markets responded well. On Monday, Citi’s stock rose 58 percent, while its credit default swaps dropped by half. But I had no confidence that Citi was out of danger. I was in Chicago that morning for the official rollout of Obama’s economic team, and Ned Kelly, a top Citi executive, called while I was on my way to the event. I asked him how the firm intended to turn itself around.

  “I haven’t the foggiest idea,” Kelly said.

  Larry and I met with the President-elect before the event at the Chicago Hilton, along with Christina Romer, who would lead his Council of Economic Advisers, and Melody Barnes, who would run his Domestic Policy Council. When Obama asked about the Citi rescue, I didn’t want to go into the details of the whole complex mess. But Larry began explaining the capital injections, the ring fence, and other features he must have gleaned from our press release. He had nice things to say about our plan, but I knew more about it, and I knew it was nothing to get excited about.

  “The details don’t matter,” I said. “It’s duct tape and string.”

  As we prepared to face the cameras, I got the sense that Larry, Christy, and Melody were looking forward to making brief statements, and there was even talk of having us answer questions. I made it clear I thought that was nuts. The theme of the event was supposed to be reviving the economy, not bailing out the banks. That would change the moment I opened my mouth in front of the media.

  “If you have me up there talking in the middle of this mess with Citi, the whole press conference will be about Citi and TARP,” I told Rahm. “You don’t want that.”

  He took my advice. The President-elect introduced me that day as “the chief economic spokesman for my administration,” but I didn’t speak. I stood silently in the background, a more familiar and comfortable role for me.

  I knew I wouldn’t have that luxury for long.

  As I prepared to leave the New York Fed, it was hard to fathom how much we had done since the crisis began, and how much the financial world had changed.

  The Fed had overseen an aggressive easing of monetary policy, reducing our target interest rate from 5.25 percent in September 2007 to as close as it can go to zero in December 2008. Ben had also launched a “quantitative easing” program, buying bonds to provide further monetary stimulus for the economy. We had expanded the Fed’s balance sheet from $870 billion to $2.2 trillion with our new credit and liquidity programs, extending our lending far beyond the U.S. commercial banking system, financing a broad range of collateral for a broad array of nonbanks. We were lending hundreds of billions of dollars to the financial system every day, supporting the tri-party repo market and backstopping the commercial paper market, while the Treasury was guaranteeing money market funds. The Fed had become a true lender of last resort for the world, providing unlimited foreign exchange swaps to major central banks, even lending dollars to emerging markets in Brazil, Mexico, South Korea, and Singapore.

  We had also used our authorities in all kinds of new ways to rescue failing financial firms, arrange shotgun financial marriages, and avoid cascading waves of financial failures. We had avoided an early disintegration of short-term funding by convincing Bank of New York Mellon to unwind Countrywide’s repo book. We had helped guide a collapsing Bear Stearns into the arms of JPMorgan, taking on part of its risky mortgage portfolio. The Bush administration had placed Fannie Mae and Freddie Mac into conservatorship, injecting $200 billion in capital, ensuring they could help offset the disappearance of private mortgage credit. We had helped set up Bank of America’s takeover of Merrill Lynch, JPMorgan’s takeover of Washington Mutual, and Wells Fargo’s takeover of Wachovia—all risky and messy deals, but all preferable to government takeovers or uncontrolled failures. We had rescued and re-rescued AIG. And we had ended the era of unregulated investment banks, letting Goldman Sachs and Morgan Stanley become bank holding companies while forcing them to raise capital.

  With the passage of TARP, we hoped to move from ad hoc emergency interventions to a more coordinated approach. We persuaded the FDIC to provide powerful guarantees for the banking system, and we began providing huge infusions of new capital for vulnerable institutions. But we still had to intervene with more aid to prevent Citigroup’s demise. And Hank, Ben, and Sheila soon had to do a similar deal for Bank of America, because Merrill Lynch was sinking again; its estimated fourth-quarter losses soared from $5 billion to $12 billion in a month, and Ken Lewis was threatening to abandon the merger. I did not participate in these negotiations, but Hank and Ben kept me in the loop, and I fully supported their efforts to make sure the merger went through and Merrill didn’t become another Lehman.

  It had been a brutal year. Of the twenty-five largest financial institutions at the start of 2008, thirteen either failed (Lehman, WaMu), received government help to avoid failure (Fannie, Freddie, AIG, Citi, BofA), merged to avoid failure (Countrywide, Bear, Merrill, Wachovia), or transformed their business structure to avoid failure (Morgan Stanley, Goldman). The stock market dropped more than 40 percent from its 2007 peak. We did an extraordinary amount of unprecedented stuff, and we successfully slowed the run on the core of the banking system. But when I looked at the broader economic issues I would face at Treasury, everything else was still getting worse. The contagion had spread far beyond finance to the cars, homes, malls, and factories that made up the everyday American experience. No matter how much money the Fed pumped into the financial system, no matter how low it reduced interest rates, its efforts to strengthen growth were being undermined by the overhang of excessive borrowing that triggered the crisis and by a critically damaged financial system. Low rates didn’t matter much when few Americans wanted to borrow and few banks wanted to lend.

  We had slipped into an economic black hole. The loss of wealth from the declines in stock and home prices, much larger than the loss of wealth before the Depression, was depressing demand and confidence. The private sector was pulling back in preparation for a Depression-like scenario, which also depressed demand and confidence. Layoffs and foreclosures left families too broke and scared to spend, which again meant less demand and confidence, more layoffs and foreclosures.

  Lehman, WaMu, and the trauma of the fall had been a financial earthquake, and now the economic tsunami was reaching the shore. The Labor Department reported a horrific 533,000 jobs lost in November, which would later be revised to 775,000, the worst month since World War II. Unemployment rose to 6.7 percent. Prices were falling at the fastest rate since the Depr
ession, a reflection of vanishing demand. General Motors and Chrysler were hurtling toward bankruptcy. Again with my encouragement and support, Hank agreed to lend them $17.4 billion from TARP to tide them over until the new administration.

  The President-elect would be inheriting an economy in absolute free fall, suffering not from a sudden loss of its ability to produce things, but from an acute shortfall of demand. And even though the panic in the markets had subsided a bit, the financial system was still broken. Our credit channels were frozen. Months of zigzags had left the world unsure whether the U.S. government was willing and able to prevent additional defaults by major institutions. And this was not a stable state. As the recession intensified, the price of securities would keep falling, increasing fears about the solvency of financial institutions.

  “With the recent sharp deterioration in the already weak economic outlook, there is considerable potential for a severe adverse feedback loop between economic activity and the stability of the financial system,” Larry and I wrote in an early policy memo to the President-elect. “Despite the dramatic actions already undertaken to strengthen our financial institutions and improve the functioning of our financial markets, nearly every segment of our financial system remains under extraordinary strain.”

  My brief optimism that we would avoid a reprise of the 1930s was gone. During this limbo period I went to see Ben and told him he needed to develop a plan for catastrophe. He needed someone else thinking about worst-case scenarios day and night, because I was already halfway out the door.

  “I have a plan for catastrophe,” Ben said with a smile. “My plan is to call you.”

  That was touching, but not comforting. In many ways, I felt like it was already all on me—the financial system, the economy, everything. And I didn’t have a plan yet, either.

  SEVEN

  Into the Fire

  On a conference call early in the transition, President-elect Obama wanted to discuss what he should try to accomplish in his first term. I responded first.

  “Your accomplishment is going to be preventing a second Great Depression,” I said.

  After campaigning for two years on an expansive agenda of change, that was not what the President-elect wanted to hear.

  “That’s not enough for me,” he shot back. “I’m not going to be defined by what I’ve prevented.”

  He wanted to reform health care, education, and the financial system that had dragged us into this mess. He wanted to reduce our dependence on foreign oil and other carbon-emitting fossil fuels. He wanted to give the poor and the middle class some tax relief while asking the wealthy to pay a bit more. I supported all those priorities, but during the worst economic meltdown in seventy-five years, I didn’t think they could be our top priorities.

  “If you don’t prevent a depression, you won’t be able to do anything else,” I said.

  “I know. But it’s not enough,” the President-elect repeated.

  The conversation soon turned to the design of his fiscal stimulus package, an effort to pour hundreds of billions of public dollars into the economy to offset the collapse of private demand. The Recovery Act’s temporary tax cuts and government spending would follow the Keynesian playbook for stimulating short-term economic activity and creating jobs during a downturn. At the same time, the President-elect wanted to use the stimulus to promote his long-term agenda, funding priorities such as clean energy, scientific research, and middle-class tax cuts. He kept asking us whether the Recovery Act ought to focus on a single transformative initiative, like a “smart electric grid” that could be a twenty-first-century analog of the interstate highways, or whether we should use it to usher in a variety of reforms and investments.

  His ambition was compelling. Why not try to make the stimulus capture the imagination? Investing in renewable energy and scientific research would create jobs for solar installers and lab assistants in the near term, while laying a foundation for stronger growth in the future. Obama wasn’t naïve about Washington; he just wanted to use his post-election political capital to do big things. He intended to expand the limits of what was possible, rather than shrink his policy ambitions to fit the existing political constraints. As Rahm said, a crisis would be a terrible thing to waste.

  Still, the visionary brainstorming made me a bit uneasy. I wanted him to be able to do big things, too, but my immediate ambitions were narrower, dominated by the imperatives of the crisis. We needed to design a strategy to fix the broken financial system and a large fiscal stimulus package to arrest the economic free fall. We had to figure out a way to save the dying U.S. auto industry in order to prevent a regional depression in the industrial Midwest. We had to devise a plan to deal with the escalating housing crisis in order to protect millions of families at risk of foreclosure. At a time when the federal deficit was soaring past $1 trillion for the first time, we would also have to send Congress a budget laying out our tax and spending priorities, and demonstrating how we intended to limit the red ink once the economy recovered. Presidential transitions are usually a confused mess of jockeying for jobs and groping for ideas, but this one would be consumed by the economic emergency.

  Larry and I would share responsibility for these challenges, though he would take the lead on the fiscal stimulus and I would carry most of the burden on the financial rescue. We asked the private equity investor Steve Rattner to lead a team dealing with the auto industry; he would work with Ron Bloom, an investment banker with roots in the labor movement. Peter Orszag, who would run the White House Office of Management and Budget, took the lead on budget matters. Christy Romer, the incoming head of the Council of Economic Advisers, would provide advice on all economic policy issues. And we had a team of experts helping us on housing.

  The pace was frantic, the pressure overwhelming. I was worried the world was coming to an end and not sure we could stop it. I wasn’t wrapped up in the spirit of limitless possibility and new beginnings that had driven the Obama campaign; I felt none of the spark and excitement that pervaded the halls of the transition headquarters. I remember one day, during the transition, the incoming cabinet and White House staff had to pose for portraits by the celebrity photographer Annie Leibovitz. All I could think was: What a weird and preening thing for us to do while the world is burning.

  I missed Carole and the kids. I was flying up to New York to see them on the weekends, when I could, but even when I was with them, I wasn’t really with them; I was lost in strategy about the crisis, or attached to a phone or two. In Washington, I stayed with my former Dartmouth classmate and Treasury colleague Dan Zelikow, who gave me refuge in a third-floor bedroom in his townhouse until the school year was over and my family could move down. I left for work so early and came home so late that I rarely saw Dan or his family, either. He later said I was like a ghost.

  I spent my days in a spartan office on the eighth floor of the Obama transition team’s cramped, nondescript headquarters in downtown Washington, mostly attending marathon meetings with Larry and the economic team, some more productive than others. We endured so many PowerPoint presentations I began complaining about Death by Deck. There was a pretty good spirit of cooperation, but also some typical tensions over turf and power and who got to attend which meetings. Orszag, a former Clinton White House economist who had been running the Congressional Budget Office, was trying to establish early dominance over fiscal policy, signaling to Larry that there would be only one budget director. Romer, a newcomer to government and to a group that knew one another from the Clinton years, was trying to establish her credibility with the President-elect, and was understandably wary of being eclipsed by Larry.

  I remember Larry asking me after one three-hour Recovery Act meeting in a windowless conference room how I thought it had gone.

  “I guess it was pretty good,” I told him. “I mean, you did ninety percent of the talking, but you were pretty interesting.”

  I was just teasing Larry, but we had some tensions, too, mostly over the financia
l rescue. Larry’s mantra in those days was “discontinuity,” the importance of distinguishing the Obama response from the pre-Obama response. Signaling a break with the past made sense politically, given how much America hated TARP, not to mention the yearning for change after the Bush years. It also made sense legislatively, since we had obligated almost all of the first $350 billion and needed Congress to authorize the second tranche. But I didn’t like Larry’s frequent derision of Hank and Ben; I was protective of them, and of course implicated in virtually everything they had done. One of Larry’s memos to Obama was full of digs at “the mistakes of the past year and a half,” the “erratic” and “ineffective” crisis response, and “the absence of any meaningful communication about objectives.” Those critiques weren’t entirely wrong, but Larry hadn’t been there, and I didn’t think he had earned the right to second-guess with that degree of confidence.

  Larry was trying to respond to dual pressures: the imperative to fix what was broken and reduce the political risk for a new president coming fresh to the mess. I didn’t share his confidence that we could fashion a crisis response that was both effective and politically popular. I saw former Mexican President Zedillo in Washington early in the transition, and he reminded me: “No matter what you do, no matter how you do it, the people are going to hate it.” I understood the instinct to try to indulge the public’s Old Testament cravings, but there was no way a few showy populist head fakes—guidelines pushing TARP banks to lend more or pay executives less—would make America happy about bailouts. And a genuinely populist approach to the crisis—punitive conditions that would demonstrate toughness at the expense of systemic stability—would violate the Hippocratic oath to do no harm, costing the taxpayers more in the end. The people would hate that, too. And they would really hate a depression. So I didn’t care much about discontinuity. In fact, one of our first decisions was whether to replace Sheila Bair at FDIC and John Dugan at OCC, and we opted for continuity. Despite my reservations about Sheila and liberal complaints that Dugan was too close to the banks, I recommended that we ask both to stay on, and we did.