TALF wouldn’t get much media attention, but it would be remarkably effective, reviving stalled credit markets that were vital to the American Dream. The securitization markets for auto loans, student loans, and other consumer loans that had disappeared after Lehman quickly rebounded after the launch of TALF. It would be one of the least controversial planks of our strategy, because it wasn’t about the banks.
But we still had to figure out what to do about the banks.
TALF Revived Consumer Lending Markets
Consumer Asset-Backed Securities Issuance
The markets for auto loans, credit cards, and other consumer credit (excluding mortgages) that could be packaged into securities averaged nearly $20 billion per month in 2007 before grinding to a halt after Lehman fell. The Fed-Treasury TALF program brought these securitization markets back to life. They averaged about $13 billion per month after TALF launched in March 2009.
Source: U.S. Treasury Department.
THE IMPLOSION of the economy was not the only source of instability in the financial system.
The ad hoc, inconsistent crisis response of 2008—which was mostly but not entirely a result of the limits on the Fed’s and Treasury’s authority before TARP—had added to the pervasive uncertainty about what remained at risk and what we might do next. Even where we had authority to act, we had not established clear rules of the game. Investors were not only unsure how to evaluate the health of institutions during a financial crisis and an economic collapse; they were also unsure how the U.S. government might handle institutions that started falling into the abyss. Bank shareholders had no idea whether they would face substantial dilution, or a government nationalization that could wipe them out. Creditors were still worried about Lehman-style defaults and WaMu-style haircuts. We hadn’t fully committed to removing catastrophic risk from the system, and we had adjusted our approach so often that our commitments wouldn’t necessarily be trusted, anyway. There was a general sense that the U.S. government might not have the will or even the ability to do what was necessary to end the crisis.
Our Columbus Day interventions had been helpful, but not all-powerful. By limiting its guarantees to the new (but not existing) senior debts of commercial banks and bank holding companies (but not nonbanks), the FDIC had left creditors with exposure to debt that was outside that circle of protection at risk of serious losses. And because the initial TARP capital injections were in preferred rather than common stock, the market saw them more as additional medium-term debt for the banks than as permanent loss-absorbing capital. The system’s capital—its defense against insolvency in case of serious losses—still seemed inadequate. That was a problem, because major banks still had huge piles of distressed assets on their books, and were still anticipating huge losses. Citi announced an $8 billion fourth-quarter loss. Bank of America wrote down even more losses to account for Merrill’s deteriorating mortgage portfolio.
These illiquid assets were another major source of uncertainty. Reasonable people could disagree about their true value, and it mattered whether they would be worth 90 cents or 75 cents on the dollar in a calmer market. But their value in the current market was deeply distressed, often less than 50 cents on the dollar, because almost nobody was buying them. Bank balance sheets are opaque, and in such fragile and turbulent times, investors and lenders tended to assume the worst about assets and institutions. Imagine you had to sell your house tomorrow in a market where no one could get a mortgage. You’d have to sell it at a tiny fraction of its potential value. At my farewell dinner at the Fed, Jeff Lacker had quipped that my colleagues had considered giving me one of our Maiden Lane vehicles as a going-away present, since they probably wouldn’t exceed the Fed’s $25 gift limit. At the time, those assets were distressed enough to make the joke funny.
The markets had welcomed TARP, but they no longer believed that TARP was big enough to fill the system’s capital hole. The President had pledged to use at least $50 billion to address the housing crisis, so we now had about $300 billion left to repair the financial system. Fortunately, we wouldn’t need TARP money to recapitalize Fannie and Freddie, because the separate authority Hank had gotten to put capital into them was essentially unlimited; otherwise, they were hemorrhaging so badly they could have drained most of the cash we had left. But the rest of the financial system was bleeding, too. My former colleagues at the New York Fed privately estimated that the banking sector alone could still face $836 billion in additional losses in a “stress scenario” and as much as $1.246 trillion in an “extreme stress scenario.” That didn’t include losses at nonbanks such as AIG, GMAC, and GE Capital. It certainly didn’t include General Motors or Chrysler, which would also need TARP to survive.
Overall, the Fed calculated that banks could need as much as $290 billion in additional capital in the stress case and up to $684 billion in the extreme case, about 80 percent of it for the fifteen largest banks. That was more than TARP could handle. And now that financial rescues had become political kryptonite, Congress had become yet another source of uncertainty, unlikely to provide more funding if TARP ran dry. Somehow, we needed to get more power out of our remaining cash.
OUR OPERATING assumption was that we needed a “capital plus” strategy: capital plus some form of asset purchase or loss-sharing arrangement to take some additional risk off the banks. The idea with the most support in financial circles, and some populist circles, was to revive the original TARP plan by creating a government “bad bank” to buy illiquid assets from the actual banks. There was a widespread belief, often tinged with moral fervor, that we needed to cleanse their balance sheets of toxic junk, to “scrub their books” so they could lend again.
Sheila Bair was the most aggressive government advocate of a bad bank. My former colleagues at the New York Fed were pushing related proposals for a “ring fence” that would reduce the risks faced by banks by providing government guarantees for some of their scarier assets, a variant on the second round of the Citi and Bank of America rescues.
I was eager for a consensus solution, but I wasn’t sure the bad-bank or ring-fence proposals could work in practice, and Larry was typically relentless in exposing their shortcomings. With more than $1 trillion in toxic assets still locked in the banking system, the cost of buying them or guaranteeing them could far exceed what we had left in TARP. My painful experience negotiating the relatively modest Bear Stearns asset pool—as well as my exposure to the Paulson Treasury’s internal debates about asset purchases—had also left me skeptical of government efforts to buy or ring-fence distressed assets from banks that had the chance to live. Nobody had good answers to the problems of how we would decide which assets to buy or guarantee, how much to pay for them, and how to avoid getting taken to the cleaners by banks that knew the details of their assets much better than we did. Hank had brought in some top experts on securities auctions to try to solve these problems in the fall, only to abandon the effort as unworkable—and if anyone had good incentives to make asset purchases work, it was the secretary who had pledged to use the Troubled Assets Relief Program to buy troubled assets.
Ultimately, the problem of having the government set prices for assets that the market wouldn’t touch seemed insurmountable. If we set the prices too high, we’d burn though TARP, providing a huge and politically inflammatory subsidy for the banks without eliminating all the bad assets on their books or all the uncertainty about their future. And we’d probably get stuck with the worst assets, exposing taxpayers to potentially brutal losses. But if we set prices too low in order to husband our TARP dollars, banks would refuse to sell unless we somehow forced them to sell, in which case they’d take the brutal losses themselves. That would expand their capital shortfalls, eventually requiring many more TARP dollars. And no matter how we decided to price the assets, the process would be long and contentious, creating more uncertainty and run risk while it played out.
While I was thinking about this pricing problem, I remembered a suggestion that Warren
Buffett had made in the fall of 2008, when we were deciding what to do with the first tranche of TARP. Buffett had written Hank a letter suggesting that Treasury could partner with private asset managers to create an investment fund, then let the private managers decide what to buy, solving the pricing problem. Banks would get a new source of demand for assets they wanted to sell, but they would not be forced to sell at fire-sale prices that would require them to take damaging losses. And the private managers would not be tempted to pay too much for the assets, since their own money would be at risk alongside TARP money.
I reread Buffett’s letter, and I thought the idea made sense. I also thought it might appease the demand in the financial and political arenas for some kind of government effort to buy illiquid assets. But a program limited to voluntary asset purchases, while avoiding the bad bank’s price-setting problems, would necessarily be a modest program, an effort to chip away at bad assets rather than scrub anyone’s books. It would also be complex and difficult to design, which was why Hank hadn’t embraced it during the panic of the fall.
During the transition, my team began working to convert Buffett’s concept into the “Public-Private Investment Program.” They ultimately devised a smart and workable structure for PPIP, as well as another dismal crisis acronym. But we knew we still needed a more comprehensive plan to stabilize the financial system.
OVER CHRISTMAS, I escaped to Mexico to spend another family vacation glued to my phone. One evening at sunset, I called Larry from the beach to suggest a new idea for deploying TARP. I thought this new approach could recapitalize the banks, restore confidence over time, and make the financial system investable again. I first described the plan as a “valuation exercise.”
We would come to call it the stress test.
The plan aimed to impose transparency on opaque financial institutions and their opaque assets in order to reduce the uncertainty that was driving the panic. It would help markets distinguish between viable banks that were temporarily illiquid and weak banks that were essentially insolvent. Then it would help stabilize the strong as well as the weak by mobilizing a combination of private and public capital. The stress test would end up having many other virtues I didn’t foresee at the time. Kabaker later dubbed it “the gift that keeps on giving.”
There were two parts to the plan. First, the Fed would design and execute a uniform test for the largest firms, analyzing the size of the losses each institution would face in a downturn comparable to the Great Depression. For years, the banks had conducted ad hoc stress tests built around rosy scenarios they chose themselves; at the Fed, I had pushed for more rigor and less optimism, but I had never gotten much traction. Now the banks would have to prove they had enough capital to survive a true worst-case scenario, with the loss estimates determined by the independent Fed.
It was unsettling to think about what the stress test might expose, but no news can be even more destabilizing than bad news. During a crisis, investors and lenders without information tend to assume the worst and run. Of course, bad news could trigger a run, too, if it was worse than people expected. There was a real possibility that the stress test would expose unmanageable losses. But we were already living with that fear. It seemed better to dispel the uncertainty.
I did think there was some chance that the news would be better than expected, that the fears of widespread insolvency would prove excessive. Unlike the bad bank, the stress test would be forward looking. It would analyze future income as well as future losses. And each firm’s potential losses would be calculated according to an estimate, however imperfect, of the underlying long-term value of its assets, not the current fire-sale value in a market without buyers. So banks would be forced to hold capital against losses they’d incur on assets they planned to hold to maturity—potentially serious losses, because a depression would create rampant defaults in mortgages and other loans. But the banks would not be forced to hold capital against losses they’d incur by unloading assets at depressed prices during a panic—potentially catastrophic losses, because few investors had cash available to buy the assets and no one knew what they were worth.
The stress test would provide information, and hopefully a measure of confidence. The second part of the plan would provide capital.
The Fed would determine how much more of a capital buffer each bank would need to weather a catastrophic downturn, and would give each firm a chance to raise the funds privately. But if a bank failed to raise enough capital on its own, the Treasury would inject extra capital to fill the gap. In either case, shareholders would be diluted—they’d own a smaller share of the company—and the firms with the biggest problems would face the most dilution. Depending on the size of the government stake, management might be replaced. Some banks might end up effectively nationalized, with the government holding a majority of shares. But that would be a last-resort solution, not a preemptive solution. The scale of Treasury’s investment and the extent of nationalization would be determined by the scale of the firm’s capital hole and the willingness of private investors to plug it. Ultimately, I thought that by making it clear we would recapitalize the banks to levels that would allow them to withstand depression-style losses, we could make a depression less likely.
On that December call, Larry was understandably skeptical, and typically full of questions. How would the stress test work? Why would the Fed’s loss estimates be credible? What if we didn’t have enough TARP money left to fill the gaps? I certainly didn’t have all the answers yet. As we discussed the issue in the following weeks, Larry worried that the markets would see the stress test as a bogus sideshow, an effort to delay the day of reckoning for insolvent banks, a tentative solution that would dodge the bold choices needed to end the crisis.
Sometimes it was hard to tell if Larry was punching holes in an idea because he had a genuine problem with it, or just because he was a world-class hole-puncher. But in this case his initial discomfort reflected some real differences that we would continue to debate in the subsequent months, disagreements over how deep the banking system’s problems really were. As pessimistic as I was about the state of the banks, Larry made me sound cheery. He thought the rot went much deeper.
Larry believed the only credible way to assess the capital shortfalls of various institutions was to evaluate their assets at something close to current market prices. By that measure, during the worst period of illiquidity and fear since the Great Depression, just about every major institution was insolvent. So Larry worried that the stress test would be viewed as a whitewash, a mechanism to prop up zombie banks. I thought Larry’s focus on the current prices of mortgage-backed securities and other illiquid assets in the banking system was misguided, since they had been artificially depressed by the crisis. It seemed plausible that the assets might turn out to be worth significantly more than they could fetch during a panic, and that many of the major banks would turn out to be solvent. Most of my former colleagues at the Fed and my new team at Treasury agreed that the banks clearly needed more capital, but were not necessarily beyond the point of no return. We thought the stress test could demonstrate that, while also revealing how much capital each bank needed.
Larry had worked part-time at the hedge fund D. E. Shaw, and I started describing his take, a bit unkindly, as “the hedge fund view.” Hedge fund executives tended to see the banks as dumb, lumbering giants, which wasn’t necessarily wrong. But since hedge funds “marked to market” every day, updating their books to reflect current asset prices, they also thought banks should have to do the same thing. This didn’t make much sense. Banks had more stable sources of funding and different accounting rules. They were permitted to value some assets on a hold-to-maturity basis because they held some assets to maturity; the value of those assets would be determined by a borrower’s ability to pay, not day-to-day price shifts in the market. Historically, traditional bank accounting had often been abused to cover up losses, but suddenly changing the rules to make the banks take massive losses d
uring a crisis would have forced them into fire sales and killed them.
Some investors, including many hedge funds, had an interest in forcing the banks to unload distressed assets, so they could scoop up the assets on the cheap. That wasn’t Larry’s interest. He just found the hedge fund view of the market more compelling than mine. He didn’t propose an alternative solution, which was not atypical for Larry, but he was consistently skeptical of the stress test as a solution to the system’s capital deficiencies. He just thought it would delay the inevitable pain.
I couldn’t say for sure that Larry was wrong. My view was: Let’s see. If Larry was right and the system was irretrievably broken, the stress test would expose huge shortfalls, banks would fail to raise private capital, and the government would have to carry the burden of recapitalizing the financial system on its own. But if Larry’s view was right, we were doomed to end up in that situation no matter what we did. On the other hand, if Larry was wrong and most of the big banks were fixable, the stress test’s results could rally private capital off the sidelines to help fix them; we would also avoid having the taxpayers take on huge amounts of unnecessary risk, and we would be on a much quicker path to stabilize the system. In an uncertain situation, it seemed sensible to push for more information. There would be risks in whatever we did, but I thought the stress test could reduce the risks.
Larry can’t help but argue every side of every issue, and at one point he found a simple way to make my case for me. If you go to the hospital with a leg injury, he said, you don’t want amputation to be the first option. Maybe when all is said and done, you’ll end up losing the leg, but you want your doctor to try some other options first.
I didn’t think we were ready to amputate.
ON MY third full day as secretary, January 29, I was supposed to have my first one-on-one meeting with President Obama. As I was about to walk into the Oval Office, Stephanie Cutter, a veteran Democratic operative who was handling our communications strategy, told me we would have a “pool spray,” a photo opportunity for the White House press. The President and I would make brief remarks about executive compensation, responding to a report that Wall Street firms had paid their executives big bonuses while piling up record losses in 2008.
Stress Test Page 31