In FED We Trust (27 page)

Overt criticism was almost nonexistent. It was all too sudden, and everyone knew Geithner had just walked off the battlefield. Even those suspicious of his proclivity for intervention and rescues were restrained. There were lots of questions — about the Treasury’s role, about the assets the Fed was taking, and about other details. Geithner criticized the SEC, saying that when he asked for Bear Stearns’s balance sheet, he got an old one because the SEC didn’t have daily data.

Near the end of the dinner, Bernanke offered up a prediction. “This has completely changed the political debate,” he said, according to a person in the room. “Congress is going to have to do something about the mortgage market.”

He was right. Before Bear Stearns, the argument in Washington about whether the government should help homeowners with mortgages they could no longer afford had focused on practicality, fairness, and the difficulty of distinguishing deserving homeowners from undeserving. After Bear Stearns, the argument was about bailing out Wall Street versus bailing out ordinary American homeowners, a debate that would persist for another year.

In fact, though, the deal that occasioned all this reflection and soul-searching wasn’t quite yet done. Public statements made it seem as if the Fed had walked down the aisles of Bear Stearns and taken $30 billion worth of mortgage-backed securities off the shelves. It hadn’t. The terms of that deal hadn’t been settled when the Fed board voted its approval and delegated details to Geithner.

A week later, the details were still pending, and the deal was in danger of collapse. Sloppy legal work by JPMorgan’s lawyers meant the bank had agreed to stand behind Bear Stearns trades until its shareholders voted — even if it took a year to get their approval. Many Bear shareholders weren’t happy with the $2-a-share price, and it wasn’t clear they would approve the merger — which meant JPMorgan might have to guarantee Bear’s trades for a long time without owning the company. With the prospect of a Bear Stearns bankruptcy once again darkening the horizon, JPMorgan eventually agreed to pay $10 a share instead of $2.

Geithner said that if the shareholders were getting a better deal, the Fed wanted one, too. So JPMorgan agreed to eat the first $1 billion of losses in the $30 billion pool of assets that the Fed was taking. When it was finally signed on March 28, the renegotiated deal between the Fed and JPMorgan set criteria for what sort of securities were in and which were out. They had to be investment-grade securities, and the property owners on all the underlying mortgages had to be making their monthly payments. The two sides agreed to value the securities at what Bear Stearns had been carrying them on March 14. But Bear had hedged some of its exposure, and figuring out which hedge went with which security was complicated. Three more months would pass before JPMorgan Chase and the Fed — working with the money manager it had hired, BlackRock, and the auditing firm of Ernst & Young — agreed on what was in and what wasn’t. Even then, it was all so complicated that the parties couldn’t quite agree on securities that added up to $30 billion, ultimately falling about $30
million
short.

Each side privately accused the other of nickel-and-diming, but the economy was doing its own value-cutting as well. By the time the New York Fed and JPMorgan had agreed on exactly what was in the Bear Stearns portfolio at the end of June 2008, the best guess at the market value of the portfolio
was $1 billion less than it had been valued in mid-March. By the end of 2008, the Fed said the portfolio had lost another $3.2 billion in value.

“This cost … must be weighed against the effects on the American economy and American financial system of allowing this firm to collapse,” Bernanke told a Senate committee a few weeks after doing the Bear Stearns deal. By then, anyone listening closely would have recognized the chairman’s mantra implicit in his testimony:
whatever it takes
.

The day after the Fed sold Bear Stearns to JPMorgan Chase, Larry Summers stood up for the Fed on PBS’s
Charlie Rose
show. “Did the Federal Reserve need to act in an extraordinary way to preserve the system?” he asked himself. His answer: “History will judge that acting to preserve the system was wise.” While cautioning that the worst might still be ahead for the U.S. economy, Summers said his protégé Geithner and future rival Bernanke had made “an important contribution to the restoration of confidence.”

But others — including some usually sympathetic — weren’t so complimentary.

Paul Volcker told the New York Economic Club that the Fed had gone to “the very edge of its lawful and implied powers, transcending certain long embedded central banking principles and practices.” That could have been an endorsement — going to the edge is
not
going over — but Volcker’s comments were taken as criticism of Geithner and Bernanke.

Volcker’s admirers at the New York Fed were stung by what appeared to be the suggestion that Geithner and Bernanke had gone too far. A former New York Fed staffer tried to use a sports metaphor to defend the move: “If you think about basketball, you can have your toes on the line and you don’t commit a foul unless you go over the line.” Volcker later insisted to reporters — and to Geithner and Bernanke — that his point was that the law needed to be changed so someone other than the Fed was doing the rescuing. But there was a very fine line between saying (a) that the Treasury or Congress should have found some alternative way to cope with the imminent collapse
of a big financial firm so the Fed wouldn’t have to be the first responder, and (b) that Bernanke and Geithner had gone too far.

Anna Schwartz, who had been Milton Friedman’s collaborator, was unambiguous. She picked (b). She denounced the Fed — Bear Stearns loans as “a rogue operation” in a May 2008 interview: “To me, it is an open-and-shut case. The Fed had no business intervening here.”

And Vince Reinhart, who had been one of the Fed’s senior staffers before leaving in 2006, stunned his former colleagues by condemning their action as “the worst policy mistake in a generation.” It meant that the Fed would always be expected to bring money to the table when trying to arrange the rescue of a big financial firm, he said.

Three months after Bear Stearns, the Richmond Fed president, Jeffrey Lacker, made headlines with a denunciation of the Bernanke-Geithner rescue in a speech in London. The Fed should always move to stop irrational runs on the banks, the self-perpetuating kind where panic by some bank depositors leads to panic by many, Lacker said. But by preventing Bear Stearns from failing, the Fed was sowing the seeds of future crises. It was creating “moral hazard,” a term borrowed from the insurance business to describe the temptation to take bigger risks because someone else will pay the cost if things go wrong.

Like Lacker, Philadelphia’s Charles Plosser and a few other Fed officials saw the Bear Stearns rescue as the original sin that led to the risk taking that worsened the turmoil that would follow later: the Fed, they argued, had led markets, executives, and creditors of big financial institutions to take unwise risks with the understanding that they expected the Fed to step in if anything bad happened. From Stanford, John Taylor, who had criticized Greenspan, emerged as a counterweight to Larry Summers. Well before the Lehman debacle, Taylor — who was big on making rules that guided policy — attacked Bernanke, Geithner, and Paulson for failing to explain to the markets and the public the criteria for rescuing Bear Stearns so everyone would know how the same trio planned to respond the next time a big financial house got into trouble.

Most inside the Fed, though, swallowed hard and concluded Bernanke and Geithner had made the best battlefield decision possible. “There is no
question we created moral hazard by doing this. But there are moral hazard extremists who think moral hazard is such a big problem that we should never do anything that creates it,” Mishkin said after returning to Columbia University’s business school. “It is unfortunate that we didn’t have more time to think about this, but the risk is that you may go into a depression if you screw it up.”

In early April, Bernanke, Geithner, the SEC’s Cox, and Treasury’s Steel were called before the Senate Banking Committee. Senator Jim Bunning — a Kentucky Republican, former major league pitcher, and perennial critic of the Fed — ended a run of hostile questions with a particularly pertinent one: “What’s going to happen if a Merrill or a Lehman or someone like that is next?”

Congressional committees limit the time any one senator can hog the microphone, and Bunning’s time was up. The committee chairman, Chris Dodd of Connecticut, asked Bunning if he wanted a response. Bunning declined, and Bernanke and Geithner were let off the hook. Five months later, though, there would be no place to hide.

O
n Tuesday, April 15 — almost a month to the day after orchestrating the Bear Stearns sale — Paulson, Bernanke, and a handful of aides met for an hour in the Fed’s “anteroom,” a small conference space adjacent to the boardroom decorated with portraits of Fed chairmen past. Paulson carried with him a ten-page memo titled “‘Break the Glass’ Bank Recapitalization Plan.” The “glass” reference had come from a late-2007 discussion among Bush aides about a potential economic stimulus during which White House economic-policy coordinator Keith Hennessey had asked, “How big is the ax behind the glass?”

The plan — really more of a bare-bones outline — was the closest thing the Treasury had to a contingency scheme. It had been drafted by Phillip Swagel, the Treasury’s economist, and Neel Kashkari, the young former Goldman Sachs banker. Kashkari was a low-profile player back in April 2008. Still, he had been prescient in realizing that housing would require more aggressive action than the Bush administration was acknowledging publicly. In fact, as early as January 2008, he had joked to colleagues that the
next president
would be forced to use taxpayer money to buy mortgage-backed securities. Over and over he would repeat, “The next president is going to bring the hostages
home” — a reference to Iran’s 1980 release of U.S. hostages just a few minutes after Ronald Reagan succeeded Jimmy Carter. Kashkari, it turned out, was right on the inevitability, wrong on the timing. Like others in the Paulson Treasury, Kashkari and Swagel were suspicious of housing-rescue schemes being discussed by the staff of Barney Frank’s House Financial Services Committee and the Fed staff, particularly housing specialist Wayne Passmore. The April 15 meeting, which Passmore attended, was the Treasury’s attempt to offer alternatives.

The centerpiece of Kashkari and Swagel’s “Break the Glass” plan was a proposal to ask Congress for $500 billion to buy mortgage-backed securities from banks and securities firms — not the safe sort guaranteed by government-sponsored mortgage companies Fannie Mae or Freddie Mac, but the riskier sort, including subprime loans. The goal was to remove toxic assets weighing on bank balance sheets and replace them with easily traded Treasury bills so banks would look and feel healthier, and thus would be more willing to lend and more attractive to investors. With excessive optimism, Kashkari and Swagel predicted the first auction could be held just one month after the legislation was signed.

The two Treasury officials also offered four less detailed alternatives to buying assets. The government could guarantee mortgage-backed securities to make them more attractive to investors. The Federal Housing Administration could refinance mortgages one by one. The Fed could buy mortgage-backed securities, as it had from Bear Stearns. And then there was the fourth option, labeled “Alternative D.” It filled half of the last page of the relatively brief memo. It detailed a plan whereby the Treasury would ask Congress for permission “to purchase equity stakes in financial institutions” to help them “rebuild capital and resume lending without purchasing their toxic assets” — precisely where Paulson ended up six months later.

Although Bernanke knew from earlier banking crises in the United States and elsewhere that the government ultimately spent a lot of taxpayer money fixing banks, the Treasury contingency plan went nowhere, essentially because the situation didn’t look bad enough yet. Bernanke and Paulson agreed that there was no point in offering Congress a plan so far-reaching unless the crisis
was so severe that Congress would see no other option. They hoped that day wouldn’t come. In fact, it came sooner than they ever imagined.

At the New York Fed, at about the same time, Geithner asked a top lieutenant, Terry Checki, a veteran of financial crises in emerging markets, to think about what the government might do about this ever-emerging crisis. Checki devised what came to be called the Consolidated Asset Management Trust, or CAM-T. The notion was to create a freestanding entity that would draw money from private investors and borrow more on the private markets — with government backing in some form — to buy residential and commercial mortgage-l inked securities from banks at then-current market prices. The banks would get most of the proceeds in cash, but a portion would be paid in an IOU good only if the ultimate borrowers paid their loans. CAM-T was meant to help the banks, restore liquidity to the moribund mortgage market, and lure investors from the sidelines. The idea went nowhere, bogged down, among other things, in arguments over which part of the government would put up the money. Whether it might have worked — and avoided some of the pain that came later — is impossible to know. It never surfaced in public.