Stress Test

  Our other big debate involved the “bogey,” the capital level we would force banks to meet in a worst-case scenario. We all agreed we needed a new measuring stick that emphasized common equity, despite the legal and logistical hurdles of establishing new capital rules in just two months. The last set of international rules, known as Basel II, had taken nearly a decade to finalize. But as Citi and Bank of America had learned, markets no longer trusted capital that wasn’t common equity, so the Fed quickly devised a new measure known as “Tier 1 common.” The key question was how much common equity each bank would have to hold.

  Initially, some Fed staffers advocated ratios as low as 2 percent of the bank’s risk-weighted assets, but we raised the choice to 3 percent or 4 percent. Higher requirements would force banks to raise more new capital, and Lee was nervous that a tougher bogey could scare away private investors, especially if the stress test projected disastrous losses. But Larry and Jeremy Stein consistently argued for the higher number. And I encouraged Ben to adopt the stricter 4 percent standard. Again, to his credit, Ben agreed, overruling some of his staff. This exercise wouldn’t work if the markets didn’t think it was tough and credible. A disastrously high number for the system’s capital needs could kill us, but a laughably low number could hurt us, too.

  By the second half of April, we were finally seeing the Fed’s preliminary data—and to our relief, it did not seem disastrous. I told the President it looked like we would probably be able to recapitalize the system with our existing TARP resources, just two months after we had budgeted that $750 billion placeholder for a second TARP. In an April 24 briefing for the President, we said nine of the nineteen stress-tested institutions—we called them “winners”—did not appear to need any new capital. We believed five more institutions would be able to raise the capital they needed soon, so they could help finance an expanding economy.

  But we also identified five “negative outliers” that looked like they would have significant capital holes. Bank of America faced the biggest shortfall, and we were concerned that if it was unable to raise enough private capital, the government could end up with a majority stake. And the General Motors financing arm, GMAC, while not as gigantic, was a complete mess, facing huge losses and plummeting revenues.

  Lew Alexander, a former Fed and Citigroup economist who had joined our team at Treasury, drafted an “opposition research” memo with potential critiques we might face after the results were released, starting with the stress test’s insufficiently dark macroeconomic assumptions. In April, unemployment rose to 8.9 percent, already approaching the stress test’s pessimistic scenario of 10.3 percent. “Even if we convince them the methodology for estimating the losses, revenues and all the other components is sound, the results will be suspect on that basis,” Alexander wrote. He also warned that after several gloomy estimates by private analysts, the relatively manageable numbers we expected might be perceived as “simply too small.”

  The Fed’s numbers kept fluctuating as the May 7 release approached, and my team remained skittish. We were drafting an op-ed to accompany the release, and Matt Kabaker thought some revisions by a speechwriter, declaring the system had “a substantial cushion of resources to withstand the challenges ahead,” sounded overconfident.

  “My own view is that the future economic outlook is sufficiently uncertain and bleak, and the impact this test will actually have is sufficiently in flux, that the declaration of victory this draft represents is inadvisable,” Kabaker wrote. Steve Shafran, who had worked for Hank and stayed on as an adviser to me, agreed that it was too early to dance in the end zone. “Besides, the Treasury secretary is supposed to be dour and conservative—anything else is off-key,” he wrote. Lee chimed in as well: “Some hedging language is appropriate. Highly likely a pullback coming.”

  I added plenty of qualifications to the draft. But the results we ultimately released were quite reassuring. In the stressed scenario, the Fed projected about $600 billion in additional losses across the nineteen firms, in addition to the $400 billion they had already lost during the crisis—huge by historical standards but not insurmountable.

  The news about capital was even better. After taking account of some modest future earnings, as well as existing reserves and capital, the stress test found that as of January 1, the nineteen firms needed an additional $185 billion in capital. But those firms—mostly Citi—had already increased their common equity by $110 billion since January 1. That meant the ten firms that still needed capital would have to raise only another $75 billion. We thought they could do most of that without new TARP dollars.

  Bank of America had the largest need at $33.9 billion, a significant but manageable problem for such a giant institution, especially after the Citi share conversion of TARP preferred shares into common equity provided a model. Wells Fargo—whose CEO, Dick Kovacevich, had scoffed that he didn’t need more capital when we unveiled the TARP injections, and had called the stress test “asinine”—was next with $13.7 billion. Citi needed only another $5.5 billion, because it had already increased its common equity by $87 billion. The only institution that seemed to be in deep trouble was GMAC, which was diagnosed with an $11.5 billion capital shortfall, almost twice the amount of its common equity.

  The next morning, I walked into the Oval Office for the President’s daily economics briefing with a report from Bridgewater Associates, the world’s largest hedge fund firm. Many experts, including Larry, regarded Bridgewater’s Daily Observations as among the smartest and most credible sources of private-sector economic analysis—and among the darkest about the banks. In front of the economic team and the President’s political advisers, I handed that day’s Observations to the President.

  The headline was “We Agree!”

  “The Stress Test numbers and ours are nearly the same!!!” the report began. “The regulators did an excellent job of explaining exactly what they did for this stress test, and showing the numbers that produced the results.”

  The financial markets ultimately judged the stress test to be credible, and investors were willing to provide the bulk of the new common equity required to stabilize the financial system. I shared this Bridgewater analysis with the President the day after the stress test results were released. Bridgewater’s positive assessment soon became the consensus view in the markets.

  Source: Bridgewater.

  I wasn’t dancing in the end zone, but that was a good day for the home team.

  NINE

  Getting Better, Feeling Worse

  Most Americans never heard about the stress test, and for many of those who did, it sounded like another Washington joke. Saturday Night Live had a field day with it, having an actor playing me open the show by earnestly announcing that we had given every bank a passing grade, since we didn’t want to “unfairly stigmatize banks who scored low on the test because they followed reckless lending practices or were otherwise not good at banking.” The fake me then griped that Citigroup hadn’t taken the written portion of the stress test seriously enough, revealing an answer sheet with “Geithner sucks!” scribbled next to every question. He also chastised GMAC for answering “taxpayer bailout” to every question, although he acknowledged that had been the correct answer to most of them.

  I’m sure a lot of the public saw me as that hapless, cowed-by-the-banks caricature. And I had no expectations that the stress test would transform my reputation inside the Beltway, either. It was at the White House Correspondents’ Association dinner that same Saturday night that President Obama quipped that one of his goals for his second hundred days in office would be to housetrain his new dog, Bo, so that he wouldn’t treat me like a fire hydrant.

  Nearly two years into the financial crisis, I was an official punch line. But another funny thing happened after the stress test: The crisis started to subside.

  By the time I briefed the President on the system’s progress a month later, the ten major firms with capital needs had raised their common equity by $66 billion w
ithout additional government help, leaving a mere $9 billion shortfall. And we thought all the firms except GMAC had credible plans to fill their capital holes through the private markets. After all our Hawk One/Hawk Two arguments about whether and how to nationalize major banks, after all our anguish about our dwindling TARP funds and the dim prospects of Congress approving more, those debates looked moot. We no longer thought the financial system would need lots more government assistance. We certainly didn’t think we’d need another TARP.

  As Lew Alexander had predicted, critics accused us of papering over the deeper problems in the banks, telling a happy story that the markets wouldn’t believe. “A rigorous audit it wasn’t,” Krugman wrote the day of the release. But it was a rigorous audit, and the transparency allowed everyone to see that. Despite its comparatively benign assumptions about unemployment, the stress test assumed a two-year loan loss rate of 9.1 percent, higher than the peak rates during the Great Depression and dramatically higher than anything since. The ultimate test of the stress test was whether private investors would take the risk of investing new capital in banks, and they would do that on an impressive scale, driving BofA’s stock price up 63 percent that week, and Citi’s up 35 percent. The broader markets were reassured, too. The equity market’s “fear index” dropped to its lowest level since the fall of Lehman. So did interbank lending spreads, as banks became less reluctant to lend to one another.

  There had been lulls in the panic in the fall of 2007, the following winter before Bear, and the spring after Bear. But there had never been a real sense of stability. Now nearly every financial indicator was heading the right way. During the week of the stress test, the price of credit default swaps for the six largest banks dropped by a third. And by the time the results were in, the index of financial stocks had more than doubled since hitting bottom in early March. As our strategy became clearer, and fears of widespread nationalization faded, confidence returned to the financial system, and confidence bred stability. The system had become investable again.

  The Stress Test Was Truly Stressful

  Commercial Bank Two-Year Loan Loss Rates

  The line running across the top of this chart—included in the Fed document announcing the stress test results—showed that the stress test assumed bank loan losses even worse than during the Great Depression. Perhaps more than anything else, this brutally tough assumption helped convince investors that the test was credible.

  Sources: Federal Deposit Insurance Corporation, Federal Reserve Board, and International Monetary Fund.

  Some suggested this was mostly just good luck. My team had always suspected the banking system was more solvent than it looked, but we had no way to be sure; if the stress test had revealed catastrophic problems and unmanageable capital shortfalls, it might have backfired. But the test was tough, transparent, and well-designed, which helped reduce uncertainty in the markets. And our promise to inject TARP capital into banks that needed it, combined with the FDIC’s guarantees of financial liabilities and our public no-more-Lehmans pledges, bolstered confidence that we were standing behind the system. Along with the President’s fiscal stimulus, the Fed’s monetary stimulus, TALF to restore consumer credit, and the PPIP funds to revive the market for toxic mortgage assets, we sent a concerted message that we would do whatever was necessary to put the crisis behind us. By requiring banks to hold enough capital to survive a depression, we made a depression less likely.

  The Panic and the Rescue

  Stock Market Performance—S&P 500

  The S&P 500 stock index is an imperfect but useful proxy for the arc of the crisis. The markets continued to deteriorate even after our extraordinary actions in the fall of 2008, only turning after the Recovery Act, the stress test, and the other financial initiatives of 2009.

  Source: Bloomberg.

  Now the markets were stabilizing. In a financial crisis, when people think things are bad, things can get really bad, but once people decide things are getting better, that can be self-reinforcing, too. In early June, with banks raising so much capital on their own, we announced that we were putting on hold our initial plan to have the PPIP fund buy their troubled loans, although it did buy a modest amount of their troubled securities. Meanwhile, the Fed’s emergency liquidity programs, which had been pumping $1.5 trillion into the financial system at their peak in late 2008, would drop below $400 billion by the end of the summer. These programs, widely viewed as giveaways, had been designed to be expensive for borrowers when the panic eased, so banks, investment banks, and issuers of commercial paper had an incentive to repay the Fed and exit as soon as the opportunity presented itself.

  We also gave nine of the largest banks permission to repay $67 billion of TARP capital and exit the program, an even more powerful signal of relative normalcy. Jamie Dimon had brought a fake $25 billion check to the White House meeting of bankers in March, his brash way of suggesting that JPMorgan didn’t need our help, but we had refused to let firms return our capital before the stress test could determine how much they needed and whether they could raise it privately. At the time, we had worried that even after the stress test, allowing some banks to repay might prompt markets to run from banks that didn’t. By June, those fears had subsided.

  The repayments were clearly good news for firms such as JPMorgan, Goldman Sachs, and Morgan Stanley, which got to escape the stigma of TARP and its attendant restrictions on compensation, dividends, and extravagant corporate retreats. But they were also good news for taxpayers, who cleared nearly $6 billion in profits from those nine firms. And they were good news for the financial system, expanding TARP’s firepower in case we needed to deal with new problems such as commercial real estate or municipal bond markets. During an Oval Office meeting with Larry and the President, I joked that TARP would now have plenty of cash to restructure GM and Chrysler.

  “Don’t worry, Mr. President,” I said. “The banks will pay for Larry’s auto losses.”

  That actually turned out to be right. TARP’s bank capital programs would end up earning nearly twice as much for taxpayers as it would cost to restructure GM and Chrysler.

  The success of the stress test was encouraging, but at the time, we had seen too many false dawns to let our guard down. The crisis was still percolating through the economy, posing all kinds of dangers. One day I got an email from Gene Sperling warning me that California, the world’s eighth-largest economy if it were its own country, could not issue $17 billion in bonds it needed to meet its obligations. “The California crisis might be real,” Gene wrote. He suggested that we could use TARP to create a Fannie-type enterprise for state and local governments. But we weren’t confident we had the legal authority, and the practical complexities were daunting; Congress was also hostile to the idea of rescuing states. Ultimately, we decided not to try, and California ended up having to pay its employees in IOUs for a time.

  Global confidence in U.S. economic power was badly shaken. When I spoke that spring at Beijing University, where I had studied abroad during college, one student asked if Chinese investments in U.S. government bonds were safe. I said those assets were absolutely safe. During the crisis, investors around the world had sought refuge in Treasuries, because they were perceived as the safest investment on earth. But my assurance was met by snickers of laughter from the young audience, a pretty remarkable show of how far the United States had fallen.

  On June 9, Meg McConnell sent me a long email fretting about a litany of dangers that still threatened the financial system: rising personal and corporate bankruptcies, soaring commercial real estate vacancy rates, lingering weakness in European banks, and much more. “Kind of scary when you think about it,” she wrote. Meg has a feel for the dark side of any situation, and while I wasn’t quite as concerned as she was about the exposure of Swedish banks to the Latvian exchange rate, I agreed with her main point: Our interventions to prevent bad outcomes had broken the panic, but the global economy was still terribly weak, and if we began allowing the kind
of bad outcomes we had pledged to prevent, the panic could return.

  “Things are likely still very fragile,” she wrote.

  We had a test case in July with CIT Group, a midsize commercial lender that had received $2.3 billion from TARP in late 2008 and now had major liquidity problems. It had appealed to the FDIC and the Fed for some relief, but Sheila had refused, arguing that CIT wasn’t viable and wasn’t systemic. My colleagues at Treasury were less confident than Sheila that its failure wouldn’t destabilize the system, and on the Friday when its survival was in doubt, our crisis response team settled in for a weekend of work on a possible rescue. The company’s CEO, apparently less concerned, abruptly ended a call with Lee that afternoon because he had to catch a flight to Nantucket. We were mindful of Larry’s dictum that “you can’t want it more than they do,” that it’s futile to try to save people who won’t try to save themselves.

  CIT was less than one-fifth the size of Bear Stearns, and much less active in the repo and derivative markets. Still, Lee was deeply worried about the economic fallout as well as the message we would send if we let one of the nation’s largest small business lenders fail after receiving funding through TARP. But Sheila thought the system could handle it, and an effective plan required her approval. The FDIC officially rejected CIT’s request for relief, forcing the firm to find a high-cost private loan that was basically a bridge to bankruptcy.

  This time, the markets seemed to agree with Sheila. CIT caused little damage to confidence, although its bankruptcy did cost taxpayers their $2.3 billion TARP investment. Lee says that was the moment he finally felt like the crisis was winding down.