13 Bankers: The Wall Street Takeover and the Next Financial Meltdown (29 page)

Never before has so much taxpayer money been dedicated to save an industry from the consequences of its own mistakes. In the ultimate irony, it went to an industry that had insisted for decades that it had no use for the government and would be better off regulating itself—and it was overseen by a group of policymakers who
agreed
that government should play little role in the financial sector.

OTHER PEOPLE’S MONEY

Although the financial crisis was similar to earlier meltdowns,
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especially in emerging markets, it was unique in its complexity and scale. A vigorous government response was necessary, particularly after the Lehman bankruptcy. Given the panic that seized financial markets, it was possible that a sudden evaporation of credit, coupled with rapid de-leveraging by financial institutions and corporations everywhere, could have led to a second Great Depression. However, at each point, the government had choices in how it responded to the crisis. To understand the nature of the government response, it is necessary to understand the options that were available.

The core problem was that various financial institutions were in trouble. The immediate threat was a panic-induced bank run, but the underlying issue was that the toxic securities held by banks had plummeted in value. If the banks had to liquidate those assets at current market prices, they would run the risk of becoming insolvent. In short, they needed more cash, or they needed insurance against those assets falling further in value. Broadly speaking, the government’s choices lay on a spectrum between two main options.

The first was the “blank check” option. The government, as a source of potentially unlimited money, could keep financial institutions afloat and prevent a systemic collapse by simply giving them the money they needed (by investing new capital, overpaying for banks’ assets, or insuring those assets at below-market rates). The second was the “takeover” option. The government could take over failing financial institutions and either clean them up, with the goal of ultimately returning them to private ownership, or shut them down. This is what the FDIC routinely does with smaller banks that become insolvent: it seizes their assets and then operates them in a conservatorship or sells the assets to another bank.

There has been considerable debate over whether the government had the legal authority to take over bank holding companies, as opposed to their commercial banking subsidiaries. While the takeover of holding companies was not anticipated by the regulatory scheme, the government had considerable power to dictate the terms of support to any troubled bank, both because regulators had the power to revoke the license of an insolvent bank and because the government was the only source of financing available to struggling banks.
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Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, argued that the government could have placed conditions on any financial support that enabled it to place failing institutions into conservatorship.
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Under both the blank check and the takeover scenarios, someone must take the losses. A bank is fundamentally a pile of money that is invested in a set of assets. Some of the money comes from the banks’ shareholders and the rest is borrowed from depositors and other creditors. If the assets increase in value, the bank can pay back its depositors and creditors (with interest) and the shareholders keep the gains. If the assets fall in value, the shareholders take the losses, since the bank’s debts do not change; if assets continue to fall after the shareholders have lost all their money, depositors (if they are uninsured) and creditors take a “haircut” because the bank cannot pay them back in full.

In the blank check scenario, the government keeps the bank afloat in its current form: managers keep their jobs, shareholders keep some value, and creditors are kept whole, so taxpayers bear most of the losses. Shareholders own all the “upside,” meaning that if the bank recovers and increases in value, they will reap the benefits. In the takeover scenario, by contrast, managers lose their jobs, shareholders are wiped out, and any remaining losses are shared between taxpayers and creditors. (In a crisis, creditors’ haircuts may have to be modest in order to protect those creditors from failing in turn.) Since the government now owns the bank, taxpayers can claim all the upside.

The takeover option was what the Treasury Department of Rubin and Summers (and Geithner, as treasury assistant secretary and then undersecretary for international affairs) strongly recommended for emerging market countries in the 1990s. Sick banks, they counseled, were at best a potential brake on economic recovery and at worst a serious macroeconomic risk; when investors fear a country’s banks will collapse, they often abandon its other assets as well, triggering a sharp depreciation in its currency. Even if these banks happened to be run by close friends or relatives of the ruling elite, they could not be allowed to carry on in their existing form. Either they needed to be cut loose from government support, or they needed to be taken over and cleaned up, for the good of the economy.

After the Lehman bankruptcy, it became axiomatic that another major financial institution could not be allowed to fail in an uncontrolled manner that would spark panic in the markets. The question was whether the United States would follow the advice it had handed out a decade before and thousands of miles away. Ultimately, however, it was the taxpayer who would pay to rescue the financial sector—without getting very much in return.

Over the course of the financial crisis, the principal economic policymakers—first Paulson, Bernanke, and Geithner, then Geithner (as treasury secretary), Bernanke, and Summers (as director of the National Economic Council)—devised an impressive range of schemes to shore up the banking system. Their hard work and creativity cannot be doubted. But the common feature of these schemes was that they attempted to fill the gaping hole in bank balance sheets with government subsidies, more or less crudely obscured.

The original purpose of TARP was to buy toxic assets from financial institutions. This would have the salutary effect of transferring risk from banks, which were choking on it, to the federal government, which is big enough to absorb it; besides, the official government theory was that the banks only faced a liquidity crisis, and that with its long time horizon the government could simply wait until the markets recovered. But this scheme faced a fundamental problem: if Treasury offered to pay the current market price for these assets, the banks would refuse to sell, since that would lock in losses they could not afford;
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if Treasury paid enough to solve the banks’ problems, that would constitute a massive subsidy from the taxpayer.
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Instead, the government chose to recapitalize banks by giving them cash in exchange for preferred shares (exploiting an ambiguity in the TARP legislation), beginning with the October 13 meeting. They were forced to do so by the markets, which were not convinced by the plan to buy toxic assets, and by announcements from the United Kingdom and several other European countries that they would recapitalize their banks. Putting government money into some banks is standard practice in emerging market financial crises, but the money typically comes with strict conditions in order to begin the reform process. In the United States, however, those conditions were missing. The government did not insist on market prices for its investments (as set by Warren Buffett with his investment in Goldman Sachs), fearing that some banks would decline to participate. Instead, the government bent over backward to make the deal attractive for the banks, charging below-market interest and eschewing any significant ownership—so shareholders, not taxpayers, would benefit when the banks recovered. As a result, for every $100 committed by Treasury at the October 13 meeting, $22 was a subsidy to the banking sector, according to a later report by the TARP Congressional Oversight Panel.
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(One thing that was similar to emerging markets, however, was that politically connected banks were more likely to get their hands on cheap TARP capital, according to an analysis by Jowei Chen and Connor Raso.)
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As opposition to taxpayer-funded bailouts increased, the subsidy mechanisms became more complex. In November 2008, with Citigroup struggling to fend off concerns about its viability, the government announced a second bailout package. In addition to another $20 billion investment, the government agreed to guarantee a $306 billion pool of Citigroup assets against falls in value (after the bank absorbed the first $29 billion in losses). The government received additional preferred stock in exchange for the guarantee, but there is no question that the guarantee was a subsidy; if Citigroup had had to buy such a guarantee on the open market, it could not have afforded the price.

A similar asset guarantee was provided to Bank of America in January, apparently in exchange for its agreeing—under government pressure—to complete the acquisition of Merrill Lynch in December.
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This time, the government guaranteed a $118 billion pool of assets in exchange for $4 billion in preferred stock. But in a bizarre twist, even though the deal was announced—reassuring the bank’s creditors and stabilizing its financial position—it never actually closed (because of technical difficulties in identifying the specific assets to be guaranteed). As a result, the government never got the $4 billion in preferred stock, and when Bank of America’s outlook improved it was allowed to walk away from the deal for a fee of $425 million.
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The government bailout of AIG, justified as a way of preventing complete chaos in the market for credit default swaps, turned out to be another subsidy to the banking sector. AIG’s counterparties for those credit default swaps were primarily large banks. By committing $180 billion to keep AIG afloat, the government ensured that those counterparties would be paid in full for their winnings on the bets they had made with AIG. In March 2009, under pressure from lawmakers, AIG finally released some details of who had been made whole by government money: Goldman Sachs received $12.9 billion from AIG, Merrill Lynch $6.8 billion, Bank of America $5.2 billion, and Citigroup $2.3 billion, along with several major foreign banks.
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This was cash that these banks would not have received had AIG gone bankrupt, or had it been subjected to an FDIC-style conservatorship.
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The AIG bailout illustrated the ability of major banks to take advantage of the government’s situation. A handful of major banks had purchased credit default swaps from AIG to insure $62 billion in CDOs. The AIG bailout included a plan for the New York Fed to finance a new entity (Maiden Lane III
^†
) to buy the CDOs so that AIG could then settle the credit default swaps.
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Maiden Lane III paid $30 billion (the market price) to buy the CDOs from the banks, and AIG, under instructions from the New York Fed, then paid the banks $32 billion to retire the credit default swaps. The result was that the banks received 100 cents on the dollar in what amounted to a backdoor bailout—even though AIG, prior to its bailout, had been negotiating in an attempt to get the banks to accept as little as 60 cents on the dollar.
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The banks were confident that the government would not force AIG into bankruptcy, and simply refused requests that they accept anything less. Neil Barofsky, the special inspector general for TARP, later criticized the New York Fed, which he said “refused to use its considerable leverage” to negotiate better terms.
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While TARP-funded recapitalizations and the AIG conduit managed to keep calamity at bay, they did little to address the major source of fear: the toxic assets that remained on bank balance sheets. In March, Geithner announced the Public-Private Investment Program (PPIP), another attempt to relieve banks of these assets. As always, the sticking point was the gap between the price that buyers were willing to pay for these assets and the price that banks were willing to accept. The PPIP closed the gap through public subsidies. Private investors could lever up their own money with loans from the government. If the assets they bought fell in value, they could dump those assets on the government instead of paying back the loan; this limited their downside while giving them the amplified upside created by leverage.
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However, the PPIP failed to get off the ground. When the first transaction finally occurred in September, it was a sale by the FDIC of assets that it had inherited from a failed bank. (This made no sense, since the justification for the PPIP was to relieve
banks
of their toxic assets.) The banks themselves decided that they would be better off holding on to their toxic assets and hoping for the best, aided by an April 2 decision of the Financial Accounting Standards Board that made it even easier to set their own values for assets.

What finally turned the tide were the “stress tests” (officially the Supervisory Capital Assessment Program) that federal regulators conducted on nineteen leading banks in spring 2009, with results released on May 7.
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The stated purpose of the exercise was to test whether the banks could withstand a severe economic downturn, quantify the amount of capital they would need in a worst-case scenario, and force them to raise that capital. But the more important purpose was to bolster confidence in the financial system. On one level, the exercise failed; many people doubted that the tests painted a true portrait of the banks’ potential losses, especially when it came out that the Fed actually negotiated the results with the major banks, in some cases dramatically improving the banks’ performance at the last minute.
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(
Saturday Night Live
’s parody of Geithner, to some, seemed not too far from the truth: “Eventually, at the banks’ suggestion, we dropped the asterisk and went with a pass/pass system. Tonight, I am proud to say that after the written tests were examined, every one of the nineteen banks scored a pass.”)
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