On the Brink (44 page)

Europe continued to suffer. Iceland, facing default on its obligations, had taken over two of its three largest banks and was negotiating a loan from Russia. Despite the country’s small population of some 300,000, its commercial banks had expanded aggressively to the point where their assets were several times greater than Iceland’s GDP. Now the entire country was caught in a liquidity squeeze, adding to the general jitters about Europe.

Something had to be done. The credit markets remained locked up, endangering businesses—and employment—around the world. On Tuesday, the Fed made another attempt to thaw the markets, unveiling its new Commercial Paper Funding Facility. The Fed’s first venture into the commercial paper market had been directed toward asset-backed paper issued by financial institutions. This new approach created a special purpose vehicle to buy three-month paper from all U.S. issuers, vastly improving the liquidity in the market. The new facility represented a radical move by the Fed, but Ben Bernanke and his board knew that extraordinary measures had to be taken.

That afternoon I moved a capital program one step further when Neel, Dan Jester, and I met with President Bush and a large contingent of White House staff in the Roosevelt Room. I had kept the president and his people up to date on equity investments, so he wasn’t surprised when presented with our thinking in greater detail.

From the start of the credit crisis, I had been focused on bank capital, encouraging CEOs to raise equity to strengthen their balance sheets. TARP had continued this focus. Banks were stuffed with toxic assets that they could unload only at fire-sale prices, which they were reluctant to do. By buying such assets at auction, we reasoned, we could jump-start the market, allowing banks to sell those bad assets in an orderly fashion, getting better prices and freeing up money to lend.

Initially, when we sought legislative flexibility to inject capital, I thought we might need it to save a systemically important failing institution. I had always opposed nationalization and was concerned about doing something that might take us down that path. But now I realized two crucial things: the market was deteriorating so quickly that the asset-buying program could not get under way fast enough to help. Moreover, Congress was not going to give us any more than the $700 billion we had, so we needed to make every dollar go far. And we knew the money would stretch much further if it were injected as capital that the banks could leverage. To oversimplify: assuming banks had a ten-to-one leverage ratio, injecting $70 billion in equity would give us as much impact as buying $700 billion in assets. This was the fastest way to get the most money into the banks, renew confidence in their strength, and get them lending again.

David Nason, Jeremiah Norton, and Dan Jester were working on a capital program, sorting through a variety of issues, from the type of instrument we might use to matters of pricing and other terms. They were moving quickly, but I wanted them to move even faster, and they grew accustomed to my asking for updates several times a day.

Because we were focused on supporting healthy institutions as opposed to rescuing failing ones, we considered a program in which the government would match any money the banks raised from private investors. We also explored different ways of taking an equity stake. Buying common stock would strengthen capital ratios, but common shares carried voting rights, and we wanted to avoid anything that looked like nationalization.

So we were leaning toward preferred stock that did not have voting rights (except in very limited circumstances) and could be repaid in full even if common shares substantially declined in value. Preferred is senior in priority to common stock and receives higher dividends, another bonus for the public.

We laid all of this out for the president, who listened with his usual attentiveness and concern.

“Are you still going to buy illiquid assets?” he asked.

“That’s the intent,” I said.

“You need to recognize where Congress and the American people are,” he said. “You are going to need to communicate this well.”

President Bush was right, but this dilemma haunted me throughout the crisis—how to make the public understand the grave situation we faced without inflaming the markets even further.

Certainly, we appeared to be facing an all-out run on the system. On Tuesday, fueled by concerns over bank stocks, the Dow tanked again, falling 508 points, or 5.1 percent, to 9,447; while the S&P 500 dropped below 1,000 for the first time since 2003. Bank of America’s shares plunged 26 percent, to $23.77. Morgan Stanley fell another 25 percent, to $17.65, raising the question of whether Mitsubishi UFJ would still want a deal.

I didn’t know how much more stress the system could bear.

Wednesday, October 8, 2008

It turned out that Angela Merkel’s Sunday night statement that Germany would stand behind its bank deposits was intended only as a confidence-building pledge, not as an announcement of government action. Germany would not authorize a guarantee as Ireland had. On Wednesday, the British government announced its own plan, a £500 billion ($875 billion) program to shore up its banking system. Eight banks, including the Royal Bank of Scotland and HBOS, had initially agreed to participate in the program.

The markets needed all the help we could give them. On Wednesday, in an unprecedented action, six central banks, including the Fed, the Bank of England, and the European Central Bank, all reduced policy interest rates. This was the first time in history that the Fed had coordinated a rate reduction with other banks; its federal funds rate target now stood at 1.5 percent.

European markets briefly rallied, but U.S. stocks opened lower despite these moves. LIBOR-OIS spreads soared to 325 basis points from 289 basis points the day before. And we could see the problems spreading to the emerging markets: on Wednesday, Indonesia’s stock exchange stopped trading after its main index fell 10 percent.

Given the global sweep of the problem, I knew there weren’t going to be any silver bullets for solving it. Rather, we would need to take a range of actions on a sustained basis.

While Jester and Nason worked through the details of a plan to make direct equity investments in banks, I watched the Europeans warily. We thought they might turn to a wave of defensive actions, including guarantees, not only for depositors but for unsecured bank borrowings. With fear rampant, such guarantees might help restore confidence in their banks, but they would put our banks at a disadvantage unless we did something similar.

We were seemingly watching a run on the global banking system, and we needed a blunt instrument to stop it the way our earlier guarantee of the money market funds had halted a panic in that sector. A week earlier Tim had suggested trying to get legislative authority for even more sweeping guarantees in the TARP legislation. That would have been impossible. But, as we’d noted in the PWG statement, the FDIC had the power to guarantee the debt of an individual bank.

We needed to know what the FDIC was prepared to do. After consulting with Tim, I called Sheila Bair.

We were facing a national emergency, and the Europeans were almost certain to act, I told her. Their economies were all disproportionately dependent on their banking systems: European bank assets were more than three times the size of the euro zone’s GDP, while U.S. bank assets were roughly the same size as our GDP. I asked Sheila if there was any way the FDIC could publicly commit to backing unsecured bank borrowings.

While Sheila understood the gravity of the situation, she worried that the FDIC didn’t have enough resources or the ability to assess the risk to its fund. She said she was prepared to work with me on this issue. I decided to strike while the iron was hot and proposed a meeting in my office with her and Ben, who was also eager to have a broad-based FDIC guarantee.

It was midmorning on that overcast fall day when Ben, Sheila, and I sat down together in my office, with Tim plugged in on my speakerphone from New York. I told Sheila that what she had done with Wachovia had been incredibly important. What if we applied elements of that approach more broadly?

“We’re looking to make a strong statement that we are not going to let any systemically important institutions go down,” I said.

I asked if the FDIC would be prepared to guarantee the debt of any such institution. Tim added that a broad guarantee was necessary to demonstrate a forceful commitment to protect our financial system.

I knew we were asking a lot. By law the FDIC had to use the least costly method to provide financial assistance to a failing bank, unless it invoked the systemic risk exception because it believed that an institution’s failure would seriously hurt the economy or financial stability. Now we were looking for an action that applied to all banks, not just an individual bank, and a guarantee that applied to new unsecured borrowings for bank holding companies, not just the insured institutions they owned. We weren’t going to reach an agreement today, but we needed to make progress.

Understandably, Sheila was very protective of the FDIC fund. “We only have about $35 billion, Hank.”

“If we don’t act, we are going to have multiple bank failures,” I said, “and there won’t be anything left in your fund.”

“This is vital,” Ben said.

We talked about the need for a broad guarantee of bank liabilities. Sheila finally indicated that she would keep working with us. After the meeting, I immediately sent her some draft language suggesting that “the FDIC, with the full support of the Fed and the Treasury, will use its authority and resources, as appropriate to mitigate systemic risk, by protecting depositors, protecting unsecured claims, guaranteeing liabilities, and adopting other measures to support the banking system.” I called Joel Kaplan with an encouraging update. “We may be getting there,” I said.

But I’d spoken too soon. Before long I got an e-mail from Sheila saying that she wasn’t certain she could move forward on this plan. I knew that I had overreached a bit and that my suggested language on an FDIC guarantee was too broad and general. When I called Joel again, however, I told him that I would keep working on Sheila, and that I had faith that she would come around.

In the meantime, I was determined to make a more definitive public statement about the need for capital injections, and with Michele Davis’s help I drew up a detailed update on the financial markets since TARP’s passage. I didn’t want to be too explicit—after all, we still didn’t have a program—but I wanted to build on the PWG’s statement on Monday.

“The markets want to hear that we are going to inject capital, but the politicians and the public don’t want to hear it,” she advised. “We should let the air out of the balloon a little bit at a time.”

At 3:30 p.m., during a live news conference, I released a four-and-a-half-page statement that, in describing our powers under TARP, made a point of listing first the ability to inject capital into financial institutions. I also noted that it probably would be several weeks before we made our first asset purchase. Because we still didn’t have a capital program in place, I didn’t allow a Q-and-A period. I’m sure that annoyed the press, which hadn’t had a chance to grill me since TARP had passed.

Neither my financial markets update, the British bank bailout, nor the central bank rate cuts cheered the morose markets. The Dow fell another 189 points to 9,258, and bank stocks suffered most. Bank of America’s shares dropped 7 percent, and Morgan Stanley’s fell 4.8 percent to $16.80; its CDS were above 1,100.

Adding to market woes, AIG was again bleeding. A few days earlier the company had said that it would sell everything but its property/casualty businesses to pay off its government debt. Now, it had run through most of its $85 billion loan—in barely three weeks. On Wednesday afternoon, the Federal Reserve announced it would lend an additional $37.8 billion to the company, secured by investment-grade bonds. It astonished me that not even $85 billion had been enough to stabilize the insurer.

I spoke to John Mack, and he was beside himself that the SEC’s short-selling ban would expire at midnight—before he could complete his deal with Mitsubishi UFJ. He wanted to know what Chris Cox planned to do. I agreed that the timing was terrible, but the fact was that Cox had painted himself into a corner during his TARP testimony when he promised that the SEC would lift the ban right after the legislation passed. I wondered how Morgan Stanley would pull through. The bank’s position had weakened since September 22, when it announced the investment from Mitsubishi UFJ. Its shares were now barely half that day’s price of $27, depressed by market fears that the deal would never happen. I, too, had my doubts.

Thursday, October 9, 2008

With the G-7 coming to town, Ben Bernanke and I knew we would be very busy all weekend, so we moved our Friday breakfast ahead a day. In the small conference room off my office, we grimly reviewed the dire situation in the U.S. and the need to move quickly. We agreed that we needed to outline a bold, credible plan to restore market confidence.

I briefed Ben on Treasury’s progress with the capital program and guarantees. He filled me in on the Fed’s progress in fashioning a more expansive commercial paper funding facility that would be available to all highly rated issuers, including industrial companies. Days earlier, Ben had suggested using TARP money, but I had declined. I hadn’t wanted the revamped commercial paper facility to be TARP’s first program, and we needed to save the funds, not use them for programs the Fed could fund itself. But Ben’s idea had set me thinking, and I had asked Steve Shafran to work on a facility for the frozen consumer loan market using a structure similar to what Ben had suggested, a facility in which TARP would bear the risk of the first losses.

During our quick meal, we previewed the G-7 meeting, and Ben gave me a thoughtful memo listing nine specific actions we could take to support our critical institutions. The ideas Ben suggested had already been under discussion or were in earlier drafts of our planned G-7 communiqué. This didn’t surprise me given how closely Treasury and the Fed had been working together on these issues—including the previous weekend when we were drafting the PWG statement.