In FED We Trust (23 page)

The move was what Rick Mishkin had been pushing a month earlier. But he wasn’t on the conference call to savor the victory. He was cross-country skiing at Lake Tahoe in California when he was alerted by cell phone that Bernanke had called an emergency FOMC meeting, and he couldn’t get to a secure phone line in time to take part — the standard requirement for Fed officials who dial into a call that could move the markets if it were intercepted.

After the Fed’s morning announcement the next day, January 22, financial markets showed their approval after a bearish start. Down as much as 464 points Tuesday morning, the Dow Jones Industrial Average reversed course and gained back over 300 points to end the day down “only” 128 points. European stock markets, which had also been falling sharply, did their own about-face when word of the Fed rate cut arrived. They closed up for the day.

Despite the temporary good news, Bernanke knew he was going to be accused of cutting rates to rescue the stock market, rather than to manage the economy. The same accusation had been made about Greenspan. Bernanke had already discounted the complaints. In his mind, plunging stock markets — along with all the troubling indicators — threatened to undermine confidence in an
economy that was already showing signs of weakness. The Fed was “behind the curve,” he concluded. He wanted to get ahead of it.

The timing, though, was terrible. Stock markets, it turned out, weren’t plunging on intensifying worries about the health of the global economy. Prices were falling because a big French bank, Société Générale, was secretly rushing to sell off a huge book of bets that one of its traders had made. (The bank lost about €4.9 billion, or more than $7 billion, undoing unauthorized trades done surreptitiously by a thirty-one-year-old trader, Jérôme Kerviel.) The head of the French central bank, Christian Noyer, knew what was going on but, having no reason to suspect the Fed was preparing an emergency rate cut, didn’t alert Fed officials until Wednesday.

Bad enough that the Fed was accused of rushing to rescue the stock market, rather than the overall economy; now it looked like the stock market hadn’t really needed a rescue. “It does look like they were snookered into cutting rates,” Lou Crandall, a veteran Fed watcher at Wrightson ICAP, said at the time.

If successful central banking is equal parts substance and theater — what the Fed does with interest rates and whether it looks to be calm and in control — then Bernanke had botched the theater this time. He shrugged it off, though, and the Fed cut interest rates by another one-half percentage point the following week, at its regularly scheduled meeting. The cumulative 1.25-point rate cut was the swiftest in the Fed’s recent history. Not everyone was happy: Dallas’s Richard Fisher dissented this time, fretting about inflation. But the Four Musketeers thought, finally, they had been aggressive enough to get ahead of the curve. They were wrong.

I
n the Great Panic, there will always be Before Bear Stearns and After Bear Stearns.

Before Bear Stearns
, no major financial institution had failed.
Before Bear Stearns
, the Fed was doing what central banks have done for generations: lending money for a few days, sometimes a few weeks, to solid commercial banks that couldn’t raise cash quickly on their own. The Fed lent readily, but only to banks, after the 1987 stock market crash and the September 11, 2001, terrorist attacks. It lent nothing in 1998 when it rallied Wall Street to rescue hedge fund giant Long Term Capital Management.

That nearly sacrosanct principle was violated in March 2008 when the Fed lent billions not to a bank that it supervised but to Bear Stearns, a brokerage house that had never been required to play by the Fed’s rules about how much it borrowed or how it managed its business. And Bear Stearns wasn’t a one-shot deal: the Fed said other Wall Street securities firms and investment banks could drink from the Fed’s trough, too.

For the Fed, this was, as one longtime staffer put it, “crossing the Rubicon or at least a very large tributary.” Just ten days before the Bear Stearns loan, Don Kohn, the Fed’s vice chairman, was asked at a Senate hearing about
lending to institutions other than ordinary banks. Kohn’s answer: legally permissible, but prudent only in “an emergency, very, very unusual situation.”

“I would be very cautious about opening that window more generally,” he told Christopher Dodd, chairman of the Senate Banking Committee.

All that was before, though.

After Bear Stearns
, potential buyers of any failing financial institution — Lehman Brothers, Wachovia — would ask the Fed not whether it would lend, but how much it was willing to kick in.

After Bear Stearns
, the debate would not be
whether
the Great Panic would require government bailouts but would instead be
who
would be bailed out and on what terms.

After Bear Stearns
, the line between Fed-protected, deposit-taking Main Street banks and less tightly regulated, more leveraged Wall Street investment banks was obliterated.

After Bear Stearns
, the Fed’s elastic interpretation of its power to lend to almost anyone in “unusual and exigent circumstances” would lead the Bush administration to see the Fed as the lender of
first
resort, rather than in its traditional role as the lender of
last
resort.

After Bear Stearns
, although not immediately, many members of Congress would realize for the very first time just how much power Ben Bernanke wielded and how much money was at his disposal.

Seeing imminent danger to the financial system, Bernanke and the New York Fed’s Tim Geithner had no choice but to improvise, but this was improv with stakes greater than those at any time since the 1930s. In pushing the loan for Bear Stearns, the two were discarding decades of practice intended to discourage investors and institutions from taking reckless risks on the expectation that they would profit if they were lucky and the Fed would rescue them if they weren’t.

“Central banks typically have rules. When the rules cannot easily be broken … there is frequently trouble,” the late economic historian Charles Kindleberger wrote in his classic,
Manias, Panics and Crashes
. “There is also trouble when rules are too readily broken.”

Or as Berkeley economist and blogger Brad DeLong paraphrased him during
the Great Panic: in normal times, the central bank’s appearance should always be in doubt. But it should always show up when really needed. The Fed, it was clear, was “really needed.”

By late winter 2007, all of Wall Street was confronting losses on bad mortgage investments and displaying extraordinary reluctance to lend even to one another. The shadow banking system — investment banks, hedge funds, private-equity funds, producers of and investors in securitized loans — had grown larger than the core of the banking system that the Fed was created to protect. The lesson drawn from the Panic of 1907 that led to the creation of the Fed was that banks play a unique and vital role in the economy: they take deposits and borrowed short term (the savings of the society), and they lend money for the long term to finance the investments of the society. This mismatch between taking money that can be withdrawn at any time and lending it in ways that will be paid back only over time makes them vulnerable. So they are required to set aside some money for emergencies, maintain substantial capital cushions to absorb losses, submit to government regulation to restrain them from taking imprudent risks, and are offered the privilege of borrowing from the Fed in a crisis.

After the Depression, the government tried to give savers confidence that their money was safe by offering them government-backed insurance on their deposits. It created the Securities and Exchange Commission to assure stock market investors that the game wasn’t rigged. And, with the Glass-Steagall Act of 1933 (pushed by the same Carter Glass who had played such a big role in creating the Fed), it built a wall between traditional banking (lending money) and what was seen as the riskier business of investment banking (helping companies raise money by selling securities and trading those securities).

These rules could be a nuisance to the banks and could limit their profits. So institutions outside the core banks — sometimes owned by the same parent companies — grew and evolved to dominate the financial system. Encouraged
by Greenspan, Congress repealed the Glass-Steagall Act in 1999. Big financial firms grew into banking-insurance-brokerage-trading behemoths like Citigroup. Investment banks, supposedly just outside the Fed’s safety net, became a bigger, more vital part of the system. As loans were made by one outfit, packaged into securities by another and sold to investors, and then other outfits bought and sold insurance (called “credit default swaps”) on those loans, the “shadow banking system” outside the brand-name, Fed-protected commercial banks exploded with a bewildering array of securities, each with its own acronym.

The U.S. financial regulatory system had not kept up with this change. In a division of labor that dated to the 1930s, the Fed and other bank regulators kept a close eye, sometimes not close enough, to be sure, on the banks. The Securities and Exchange Commission worried about the big securities firms (Bear Stearns, Lehman Brothers, Goldman Sachs, and the like), but more to protect their customers’ money and to enforce laws about disclosure and fraud than to make sure that the firms didn’t put the entire financial system in harm’s way. The walls dividing those businesses had eroded over time, and Congress had undone much of the New Deal legislation without finishing the job of reconstructing the financial regulatory apparatus, which was shared by a bewildering number of federal and state agencies of varying competence.

It was fine in good times. “The bottom line is simple: shadow banks use funding instruments that are
not
just as good as old-fashioned [government]-protected deposits,” said Paul McCulley, who periodically offered acerbic comments from his post as a portfolio manager at Pimco, a big West Coast bond manager. “But it was a great gig so long as the public bought the notion that such funding instruments were ‘just as good’ as bank deposits — more leverage, less regulation and more asset freedom were a path to (much) higher returns on equity in shadow banks than conventional banks.”

Suddenly, the times weren’t so good. The “public” — or at least big-money investors — didn’t view the shadow banks as quite so safe, and grew reluctant to provide the short-term money on which the shadow banks depended. In proliferating numbers, Wall Street executives were beseeching the Fed for the same loans available to ordinary commercial banks at times of duress.

Of all the firms on the Street, Bear Stearns was widely regarded as the weakest link. Funds it managed had been among the early high-profile victims of the subprime mess. Just as bad, the firm was thought to suffer from a severe leadership vacuum. The
Wall Street Journal
, in a devastating front-page November 1, 2007, story described the CEO, Jimmy Cayne, as a detached, marijuana-smoking executive who spent more time playing bridge than tending his company. Cayne, who had almost died the previous September from a severe prostate infection, stepped down in January.

On Monday, March 10, 2008, Moody’s Investors Service downgraded mortgage-backed debt issued by a Bear Stearns fund, and with that, rumors began to circulate in the market that there were liquidity problems at Bear Stearns itself. Bear Stearns denied the rumors, but the market ignored the denials. When new CEO Alan Schwartz went on CNBC Wednesday to try to shore up confidence in the firm’s finances, his appearance got upstaged by news that New York’s governor Eliot Spitzer was resigning after law-enforcement authorities discovered his dalliance with prostitutes. The run on Bear Stearns continued.

Bob Steel, the former Goldman executive who had come to Treasury to serve as Paulson’s undersecretary for domestic finance, told his boss: “They’ve got a month or so.”

“I don’t buy that,” Paulson said. “When confidence goes, it goes.” He was right.

For weeks, the Fed had been looking for a way to aid Wall Street by lubricating markets that weren’t functioning well. The week of March 10, as Bear Stearns edged toward the precipice, the Fed finally offered securities houses a deal: give us your troubled assets yearning to be sold, the wretched refuse of your lending. Specifically, the Fed created the Term Securities Lending Facility (or TSLF) to take up to $200 billion worth of Wall Street’s hard-to-sell mortgage-backed securities and exchange them for supersafe U.S. Treasury securities from the Fed’s vast portfolio for up to twenty-eight days.