Stress Test

by Timothy F. Geithner

  A wide range of my former colleagues at the Fed and Treasury spent time with Charlie, Mike, and me, going over the history of our key decisions, reviewing what we missed, reflecting on the paths we did not take. They did this generously and patiently, and with great care and reflection. They demonstrated—as they so often had in the crisis—that they were more than willing to push back at me, to disagree, and to challenge, a service that is invaluable to anyone who has had to make complicated decisions. Those long dinners and meetings made me appreciate anew how incredibly fortunate I was in the quality of people I got to serve with at the Fed and at Treasury.

  This group of participants in our effort to revisit history included Tom Baxter, Terry Checki, Bill Dudley, Meg McConnell, Helen Mucciolo, Marc Saidenberg, Mike Schetzel, Mike Silva, and Kevin Stiroh from the New York Fed; Tim Clark, Don Kohn, Sandy Krieger, Pat Parkinson, and Mark Van Der Weide from the Federal Reserve Board; and Michael Barr, Matt Kabaker, Jenni LeCompte, Mark Patterson, Lee Sachs, Laurie Schaffer, Jake Siewert, Mark Sobel, and Ted Truman from Treasury.

  In addition to my editor Vanessa Mobley, a number of former colleagues reviewed and commented on the chapters. Tom Baxter, Matt Kabaker, Jenni LeCompte, Meg McConnell, Chris Meade, Mark Patterson, Laurie Richardson, Lee Sachs, Jake Siewert, Josh Steiner, and Neal Wolin reviewed the entire book. Brad Setser and Ted Truman reviewed the international pieces. Michael Barr, Laurie Shaffer, and Mark Van Der Weide read the sections on financial reform. I am incredibly grateful for the time they spent and for the quality of their suggestions.

  My wife, Carole Geithner, stood with me, read every word, patiently commented on every chapter. I have always envied and admired her skill as a writer, and I am so lucky to be able to benefit from it in this book. She helped me remember many things I had forgotten or blocked out, and she pushed me to be more open and candid about the worst things, the fear and the anger and the doubt.

  She did not want me to be secretary of the Treasury, and she had the worst part of the deal, carrying the sense of responsibility and obligation I felt, and the loss of privacy and loss of time together as a family. I am so grateful for her love and support, for being willing to let me do work that I found so deeply interesting, consequential, and satisfying, and for helping me do it with more maturity and care and wisdom, however limited, than I ever could have done on my own.

  I am grateful to my spirited and creative children, Elise and Ben, for being patient with me, putting up with the burdens of a father in public life with grace and humor, and welcoming me back into their lives after my long absences.

  My sister, Sarah Adam, and my brothers, Jonathan and David Geithner, after relentlessly teasing me when we were kids, were protective and loyal when it meant the most to me.

  And I am so grateful to my parents, Deborah and Peter, who gave me the horizon-expanding experience of a childhood living in other countries, their shining example of generosity and humility, and the invaluable gifts of love and confidence.

  AUTHOR’S NOTE

  In writing this book, I relied on my memory of events, aided by the recollections of my colleagues and the documentary record at the Federal Reserve Bank of New York and the Treasury. This documentary record was extensive and very valuable, though it did not include comprehensive contemporaneous notes by participants of the innumerable meetings and phone calls where the consequential decisions were made.

  I did not take notes of meetings, and I wrote little of substance in email, mostly because of the extraordinary pace and burden of the events of that time. I try to describe what I was thinking, to the best of my recollection. As a check, however imperfect, against the limitations of memory, I tested my recollections against the memories of those men and women who thought through those decisions with me.

  I tried to write the bulk of this book without having read any of the existing histories that covered portions of this crisis, so that my memory was not altered by those reports. But as I got further along, I checked my account against those of other participants, most importantly Hank Paulson’s excellent book, On the Brink, and those based on extensive reporting at the time by journalists, most notably David Wessel’s In Fed We Trust and Andrew Ross Sorkin’s Too Big to Fail.

  Where I quote directly from meetings or conversations, I do so only when I am confident that I was able to capture the essence of what was said. A few of the quotes have appeared in other accounts of the crisis; I included those where I provided the quote to those authors during their reporting, or I was a witness to the conversation recounted.

  Our decisions were quite naturally the subject of extensive internal and external debate. I have tried to describe those debates and to represent fairly the beliefs of those who opposed or were uncomfortable with my choices.

  This manuscript was carefully reviewed for accuracy by a wide range of my former colleagues at the Treasury and the Fed. But I alone am responsible for any failures to accurately portray these events.

  NOTES

  Introduction: The Bombs

  1 have averaged more than 10 percent of GDP: Studies of the direct fiscal costs of the financial crisis have found that financial crisis responses are typically very expensive for taxpayers. For instance, in 2008, Luc Laeven and Fabian Valencia, both IMF researchers, published a study of forty-two financial crises between 1970 and 2007 that estimated that the direct fiscal costs, net of recoveries, averaged about 13.3 percent of GDP. In early 2009, the IMF estimated that the cost of U.S. financial crisis response would be 12.7 percent of GDP. These estimates do not take into account broader losses imposed on the economy, for instance, through lower GDP and higher unemployment.

  Two: An Education in Crisis

  1 had a fixed exchange rate: Technically, Mexico had a “crawling” exchange rate peg, meaning the government would allow the rate to move slowly over time. This was a distinction without much of a difference: The Mexican government intervened aggressively enough that the exchange rate moved far more slowly than if it had been determined by market forces, and that left it overvalued.

  2 short-term bonds called tesobonos: Tesobonos were structured so that Mexico would pay back the borrowers in however many pesos it took to produce the dollar amount of the bond. So if a dollar was worth 3 pesos, a tesobono holder owed $100 would receive 300 pesos. But if Mexico broke the peg and a dollar became worth 6 pesos, the same bondholder would receive 600 pesos. So for Mexico, borrowing in tesobonos carried some of the same currency risks as borrowing in dollars directly.

  3 But it had an immediate liquidity problem: The distinction between illiquidity and insolvency is not black-and-white, and it’s hard to apply to governments, who, after all, have the ability to tax. An insolvent firm is fundamentally unable to repay its debts in the long run, while an illiquid firm doesn’t have enough cash on hand to pay its bills coming due in the near term. If an illiquid but solvent institution is lent sufficient funds to address its near-term problems, it will be able to sustain itself over time. Lending to an insolvent institution, by contrast, risks throwing good money after bad. We thought Mexico was experiencing a “sovereign liquidity crisis”; its overall debt load was manageable, but the burden of its short-term obligations was too great.

  Three: Leaning Against the Wind

  1 “sufficient cushion against adversity”: Remarks Before the New York Bankers Association’s Annual Financial Services Forum, “Change and Challenges Facing the U.S. Financial System,” March 25, 2004.

  2 it could go to the Fed’s discount window: The “discount window” is the facility through which the Fed provides collateralized loans to depository institutions that are judged to be in sound financial condition, at a discount to the value of the collateral. This discount provides additional protection to the Fed; if the borrower were to default, the Fed would own collateral with a higher value than the amount it lent to the borrower. The name survives from the days when depository institutions would actually send a representative to a Fed bank teller window in order
to access the facility.

  3 “shadow banks”: Shadow banking is a term often used to describe entities with bank-like risk that are not regulated as banks. There is no precise definition of shadow banking, and some use it very broadly to include financial instruments as well as a wide range of financial firms, from investment banks to insurance companies to money market funds. One qualification to this popular descriptor is that many of the largest firms and markets described as “shadow” activity were operating in broad daylight, as public companies or subject to the public disclosure requirements of securities laws.

  4 Chart, The Rise of “Shadow Banking”: Methodology based on “Financial Stability Monitoring: Federal Reserve Bank of New York Staff Report no. 601” (2013), Tobias Adrian, Daniel Covitz, and Nellie Liang. “Shadow banks” derived from flow of funds data: commercial paper (L.208), federal funds and security repurchase agreements (L.207), GSE liabilities and agency- and GSE-backed mortgage pools (L.123 & L.124), asset-backed securities (L.125), and money market funds (L.120), net of GSE repo (L.207), GSE holdings of GSE debt and GSE-backed mortgage pools (L.123), ABS holdings of GSE-backed mortgage pools (L.125), money market fund holdings of repos (L.120), commercial paper (L.208), and GSE-backed securities (L.120). This does not include hedge funds and other investment funds, which some also include in definitions of “shadow banking.”

  5 exploiting their implicit federal backstop: Prior to the crisis, markets expected that the government would step in to prevent the failure of Fannie and Freddie if they ran into trouble, in part because they were “government sponsored.” There was no explicit legal requirement for the government to bail them out, and government officials would loudly deny that any “implicit guarantee” existed. But Fannie and Freddie were able borrow at cheap interest rates, reflecting the expectation of government support.

  6 “risk-weighted assets”: A bank’s capital level is generally expressed as a ratio relative to its assets, adjusted for their riskiness. These “risk weightings” mean that the bank has to hold less capital against safe assets like Treasuries as compared to riskier assets like corporate loans. However, risk-weightings before the crisis were crude and did a poor job of fully differentiating between the riskiness of assets.

  7 leverage dramatically increases “wipeout risk”: Under the regulations that applied at the time, a bank had to have about $8 of “capital” for every $100 of risk-weighted assets, and about $3 of capital for every $100 of total assets, without adjusting for risk. But, in addition to common equity, banks were allowed to count as capital a variety of hybrid debt-like instruments, such as trust-preferred securities (TruPS) and cumulative perpetual preferred securities, which were less able to absorb losses in a downturn. Investment banks and other nonbanks had no comparable constraints on leverage during the boom, and the markets enabled some of those institutions to take on significantly more leverage than banks were allowed to under the prevailing regulations.

  8 “even at the most sophisticated institutions”: Remarks at the Institute of International Bankers Luncheon in New York City, “Challenges in Risk Management,” October 18, 2005.

  9 “could be more acute”: Remarks at the Institute of International Finance, Inc.’s Annual Membership Meeting in Washington, D.C., September 25, 2005.

  10 “future stresses to the financial system”: Remarks Before the Economic Club of New York, “Perspectives on the U.S. Financial System,” May 27, 2004.

  11 “prepare for war or instability”: Remarks Before the Conference on Systemic Financial Crises at the Federal Reserve Bank of Chicago, “Changes in the Structure of the U.S. Financial System and Implications for Systemic Risk,” October 1, 2004. This is an adaptation of a common maxim among military analysts.

  12 “How do we generate … the immediate future looks strong?”: Remarks Before the Economic Club of Washington, D.C., February 9, 2005.

  13 just 3 percent of assets … barely 1 percent of the assets: These capital ratios are measures of common equity relative to total assets. Because the investment banks and Fannie and Freddie were not regulated like banks, there were not good comparative measures of capital relative to risk-weighted assets for investment banks or GSEs in the pre-crisis period.

  14 imposed few constraints on leverage: The SEC created the Consolidated Supervised Entity (CSE) program in 2004 to supervise the investment banks on a consolidated basis, meaning that the SEC would be responsible for supervising all of their subsidiaries. The program was developed in response to requirements that financial firms operating in Europe have a consolidated supervisor—and the threat that if we didn’t figure out a way to supervise our investment banks the Europeans would do it for us. But the investment banks participated in this program voluntarily; the SEC did not have the legal authority available to bank supervisors to impose bank-like limits on leverage and liquidity risks, and systemic risk was not their mandate or their expertise.

  15 crises that do erupt more damaging and harder to contain: Remarks at the New York University Stern School of Business Third Credit Risk Conference, New York City, “Implications of Growth in Credit Derivatives for Financial Stability,” May 16, 2006; Remarks at the Distinguished Lecture 2006, sponsored by the Hong Kong Monetary Authority and Hong Kong Association of Banks, Hong Kong, “Hedge Funds and Derivatives and Their Implications for the Financial System,” September 15, 2006.

  16 Trades remained unconfirmed for months: Post-trade confirmation is an important part of the process of completing a derivatives transaction. Leaving a trade unconfirmed can result in large amounts of legal uncertainty, accelerating fear if the validity of a trade is called into question during periods of increased market stress. The back office plumbing for derivatives was so primitive that often trade information would be exchanged by phone or fax, scribbled on paper, and stuffed in desk drawers or filing cabinets.

  17 adjusting the “federal funds rate”: To raise or lower interest rates, the Federal Open Market Committee (FOMC) traditionally establishes a “target” rate for short-term lending between banks. It then executes this monetary policy by buying and selling securities through “open market operations,” so that the effective federal funds rate (the rate actually paid for banks to borrow from one another) stays close to the target rate.

  18 that the “Greenspan Put”: A “put” is a derivatives transaction in which one party insures the other against a decline in the value of a particular asset. When central banks adopt accommodating monetary policies in response to market distress, critics often condemn them as giving investors an implied, broad-based put—in the form of protection from the risk of further declines in prices.

  19 a situation Greenspan dubbed “the conundrum”: Ordinarily, the Fed can influence the rates on mortgages and other long-term debt by adjusting short-term rates. But this relationship broke down during my time at the New York Fed; as Alan Greenspan noted in his crisis postmortem, the correlation between long-term and short-term rates dropped from 0.86 in the twenty years that preceded the pre-crisis bubble to 0.10 in the period from 2002 to 2005.

  20 “adverse tail, or the negative extreme”: Remarks at the 2007 Credit Markets Symposium hosted by the Federal Reserve Bank of Richmond, Charlotte, North Carolina, “Credit Markets Innovations and Their Implications,” March 23, 2007.

  Four: Letting It Burn

  1 “commercial paper”: Commercial paper is short-term debt that matures within 270 days. Broadly speaking, it comes in two forms. “Unsecured” commercial paper represents a general obligation of the company that issues it; its riskiness depends on the creditworthiness of the issuer (that is, the borrower). “Asset-backed” commercial paper (often referred to as “ABCP”) is secured by collateral, such as mortgage-backed securities; its riskiness depends on both the quality of the underlying assets and any financial support promised, or perceived to be promised, by the company arranging for the issuance of the ABCP. Countrywide funded its business with both unsecured commercial paper and ABCP.

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p; 2 BoNY’s role in tri-party repo: Under a repurchase agreement (or a “repo”), one party agrees to sell securities to another party, while agreeing to repurchase them at a pre-specified price and date, often as soon as the next day—in effect a short-term, secured loan. This allows the “borrower” of a repo to borrow cash from the “lender,” using the underlying securities as collateral. In the “tri-party” repo market, a “clearing bank” functions as a third party facilitating this transaction, matching lenders and borrowers and managing the flows of cash and securities. This market peaked at $2.7 trillion in 2008. But the two clearing banks (JPMorgan and BoNY Mellon) were themselves taking poorly understood risks, exposing themselves to possible loss if borrowers defaulted during the day. Despite the fact that the vast majority of underlying collateral was very high quality (such as Treasuries and agencies), the tri-party repo market became increasingly focused on the risk that a borrower would default. If an anxious clearing bank decided that it didn’t want this exposure to a particular firm, it could immediately threaten the viability of that firm—and the stability of the entire tri-party repo market.

  3 Money market funds need to remain liquid: Money market funds are mutual funds that—because of a special regulatory exemption devised in the 1980s after intense industry lobbying—behave in many ways like banks, but without any of the safeguards of banking. They were some of the most active lenders in commercial paper and tri-party repo markets, financing companies like Countrywide. However, because of SEC restrictions on the types of securities they could hold, a default by a major counterparty would require them to quickly liquidate the mortgage securities that might collateralize those repos. This meant that if Countrywide defaulted and the money funds got stuck with the collateral, they would be forced to sell it—at the worst possible time, pushing down prices and further destabilizing markets, potentially in fire-sale conditions.