In FED We Trust (28 page)

In July, as Congress reprised Bear Stearns and all that followed, Bernanke and Paulson testified before Barney Frank’s House Financial Services Committee. They told Frank and his colleagues that federal law needed to be changed so the government could better cope with the failure of big financial institutions other than conventional banks. Although there was no argument on the necessity of this legislation, neither Bernanke nor Paulson gave any hint that they thought large sums of taxpayer money might be needed soon. Nor did either man suggest that they wanted Congress to move during 2008 on anything except legislation tightening regulation of Fannie Mae and Freddie Mac, the big mortgage companies.

Paulson and Frank — who had fashioned a good working relationship before the Great Panic — talked privately ahead of the hearing. Frank told Paulson
and Bernanke in person what he had told the secretary on the phone: take an expansive view of your powers, and I won’t criticize you for that. If you need more power, don’t ask us to give it to you until you’re sure we can do it. The last thing we need now is for you to ask us for something and we say no. Paulson and Bernanke replied that they didn’t have all the power that they’d like, as both had pointed out before, but they had enough to cope with what they currently confronted. Paulson softened his testimony to suit Frank’s request. “The chance of our getting this in an election year was zero,” Paulson said in an interview a few months later.

In the public hearing, Paulson and Bernanke said bluntly that they didn’t think Congress could tackle major changes to financial regulation in an election year. “The more complex issues like resolution [of failing financial institutions] or even financial regulatory restructuring are simply not likely to happen in the short term, and we need to take the time to make sure it’s done right and thoroughly worked through,” Bernanke said, his words reflecting Barney Frank’s advice. “So we will continue to think about what steps might be taken on a shorter-term basis and be in close touch with Congress. But … I just want to be clear that it’s not that we don’t have any tools. We have plenty of tools, and we are working together very well, I think, to address a difficult situation.”

Paulson — who was less inclined than Bernanke to accommodate Frank’s request — was less reassuring and did just a little finger-pointing. “[R]egulators are working together seamlessly to address some of the issues that have arisen, and I think progress has been made,” he said, but there were problems. “Work should begin immediately and urgently on … these steps we’ve suggested. We’re just telling you that realistically, because we’ve heard from you and we know it to be the case, realistically it’s going to be difficult to get things done this year. But this is going to take some time, so begin work urgently on that.”

Frank, Paulson, and Bernanke came away from their private conversation and the hearing with different interpretations. Frank concluded that Paulson and Bernanke couldn’t make a strong case that they needed more power to deal with the “next Bear Stearns,” so Congress didn’t need to do anything urgently. Paulson and Bernanke concluded that there wasn’t any point in asking Congress — unless the crisis intensified to the point where there were no other options. Either way, it boiled down to the same result: waiting until
it was too late. There was no serious attempt to get Congress to swiftly grant the Treasury or the Fed the power to deal with the imminent collapse of another financial institution that wasn’t a bank.

Fannie and Freddie wouldn’t wait. Their capital issues were quickly turning into another financial emergency — an unsurprising situation given that the two highly leveraged mortgage giants were wholly invested in housing and the housing bubble was bursting. Warnings about the two companies stretched back to well before their current troubles. Larry Summers, when he was at Treasury in the Clinton years, and Alan Greenspan, when he was at the Fed, had warned that the two companies had grown so large that they posed risks to the whole financial system. In the Bush White House, encouraged by chief of staff Andy Card, Kevin Warsh pressed a campaign to rein in the companies — and he had plenty of allies at the Fed when he moved there.

More than a year earlier, in March 2007, Bernanke himself had warned, “Financial crises are extremely difficult to anticipate, and each episode of financial instability seems to have unique aspects. But two conditions are common to most such events. First, major crises usually involve financial institutions or markets that are either very large or play some critical role in the financial system. Second, the origins of most financial crises (excluding, perhaps, those attributable to natural disasters, war, and other nonfinancial events) can be traced to failures of due diligence or ‘market discipline’ by an important group of market participants. Both of these conditions apply to the current situation of Fannie Mae and Freddie Mac.” At the time he spoke, the companies had $5.2 trillion in debt and other obligations outstanding, even more than the federal government’s $4.9 trillion in publicly held debt.

Fannie and Freddie were unusual companies. Since 1972, they had been owned by shareholders and run for profit, but they borrowed all over the world at low interest rates because investors, including the Chinese government, assumed — correctly — that the U.S. government stood behind their debt, even though it didn’t have any legal obligation to do so. The companies
used the money not only to guarantee repayment of mortgages that they had turned into securities but also to build massive portfolios of mortgages. They made their money by exploiting the difference between the low rates they paid to borrow (thanks to the perceived U.S. government backing) and the higher rates on the mortgages they held. For years, the fear had been that Fannie or Freddie would mismanage the risks they were taking by borrowing big and lending big and counting on sophisticated hedging techniques to be sure that an unanticipated swing in interest rates didn’t sink their portfolios and bring down the companies. But that wasn’t the big problem now: Fannie and Freddie hadn’t anticipated that housing prices would fall so far so long and that so many homeowners would stop paying their mortgages. No one had. These losses — which hit their portfolios of mortgages as well as the guarantees they had made on mortgages turned into securities sold to others — were eroding their capital. But markets and the Chinese traditionally hadn’t worried about the skimpiness of their capital because they figured the U.S. government would never let them fail.

The companies long had been targeted by the banks that competed with them and Republican champions of free markets, but they cultivated strong political backing in Congress, particularly (although not exclusively) among Democrats and the housing industry. The national goal, Bush himself had proclaimed, was homeownership for all. Fannie and Freddie styled themselves as the means to that end, and they used their political clout to stymie Bush administration attempts to restrain them. Much like Goldman Sachs, Fannie and Freddie seemed to be the employer of last resort for people moving out of government or preparing to go into government, and not only for Democrats. Stephen Friedman, the former Goldman executive who was for a time Bush’s economic-policy coordinator, had been on Fannie’s board, for instance, and, as result, was recused from dealing with the issues. A top Freddie Mac executive, Hollis McLaughlin, had been Treasury Secretary Nick Brady’s chief of staff. Bob Zoellick, who was Bush’s first trade representative and then president of the World Bank, had been an executive vice president at Fannie Mae. (The Obama administration continued the tradition: Thomas Donilon, the deputy national security adviser, had overseen Fannie Mae’s lobbying. But in a telling sign that the companies had lost their mojo, candidate Obama bowed
to criticism after he designated former Fannie Mae CEO Jim Johnson to oversee his vice presidential search and then quickly replaced him.)

Both companies had been weakened — both politically and otherwise — by accusations of improper accounting, which claimed the jobs of their chief executives. But their size, unique ability to borrow huge sums, and vulnerability to falling house prices placed them high on the worry list at both the Fed and the Bush White House — though not on Paulson’s own worry list when he arrived at Treasury in 2006.

Over the summer of 2008, however, housing prices sank and Fannie’s and Freddie’s losses mounted. Foreign governments began peppering the Treasury and the Fed with questions about the safety of the loans they had made to the companies and the mortgage-backed securities they had purchased because Fannie and Freddie guaranteed them. By early July, the shares of the two companies had fallen more than 60 percent since the beginning of the year, and they had to pay more to borrow.

Alarmed at the prospect that one or both of the companies might falter at a moment when the housing market needed them more than ever, Paulson and Bernanke and their staffs scurried to devise an emergency rescue. By Thursday, July 10, Paulson had concluded that Fannie Mae and Freddie Mac would need help the following week. By the weekend, he was saying that the companies needed support before — when else? — Asian markets opened Sunday night, Washington time.

That Sunday night, on the steps of the Treasury building, Paulson unveiled the rescue plan as TV cameras filmed. He asked Congress to give him the power to lend unlimited sums to the companies or to invest taxpayer money in their shares if they needed capital. Because Congress couldn’t act before the markets opened, the Fed declared the circumstances to be “unusual and exigent” — again — and said on Sunday that it would lend Fannie and Freddie the money if they needed any before Congress acted. Once again, the Fed ended up the first responder; no alternative existed. The government hadn’t gone all the way toward explicitly guaranteeing Fannie’s and Freddie’s debt, but it had — as the officials put it — “hardened the implicit guarantee.”

To the consternation of some at the Fed, the Treasury had managed to make it appear to many outsiders that Bear Stearns was a Fed-run operation.
This time, even though the Fed and its staff were all over Fannie and Freddie, the rescue was seen as Treasury-led. While this relative anonymity was a relief, the Fed wasn’t off the hook. The Paulson legislation assigned the Fed — for the first time — a formal “consultative” role in overseeing the mortgage giants, another broadening of its purview that made some insiders uncomfortable. The more the Fed got involved in these politically charged bailouts, the more it risked its prized independence in setting interest rates in the future to guide the economy without fear of political interference.

Paulson still had to sell Congress on giving him nearly unlimited authority to pump money into the mortgage giants. It was a hard sell. “If you’re not used to thinking about these issues, it seems counterintuitive,” Paulson told a Senate committee. “But if you’re used to thinking about the issues, it is very intuitive. …[I]f you’ve got a squirt gun in your pocket, you may have to take it out. If you’ve got a bazooka, and people know you’ve got it, you may not have to take it out. …By increasing confidence, it will greatly reduce the likelihood it will ever be used.”

BERNANKE’S DASHBOARD
August 22, 2008

As graphic as it was, the ad-lib was a mistake. The strategy made sense; talking about it didn’t. It was as if the Treasury secretary were waving a gun and threatening to shoot, but at the same time promising he didn’t expect to use it. When he fired the bazooka a few weeks later, he hurt his credibility with members of Congress who felt misled.
Fortune
magazine labeled the
remark one of 2008’s 21 Dumbest Moments in Business. Paulson had, again, messed up the theater, the managing of expectations and the appearance of calm, reasoned policies that are essential ingredients at a moment of widespread anxiety and panic.

By the end of July, after intensive lobbying by Paulson, Bernanke, and — this time — the White House, Congress granted the Treasury’s request, an extraordinary grant of power to the Treasury secretary that some of Paulson’s aides thought he would never be able to convince Congress to give him. Paulson considered passage of the legislation one of his biggest successes, and cited it as evidence that he had built strong relationships with key members of Congress of both parties. But handing Paulson his bazooka didn’t solve Fannie’s and Freddie’s problems immediately. For one, the whole operation seemed to call attention to the fact that Fannie’s and Freddie’s debt hadn’t actually been legally guaranteed by the U.S. government — causing consternation among top political leaders in China and other nations whose underlings had invested money.

From retirement, where he showed no interest in fading into obscurity, Greenspan blasted the operation: “They should have wiped out the shareholders, nationalized the institutions with legislation that they are to be reconstituted — with necessary taxpayer support to make them financially viable — as five or ten individual privately held units,” which the government would eventually auction off to private investors, he said.

When Fed officials traipsed off to their annual conference at Jackson Lake Lodge in the Great Tetons over the weekend of August 23 and 24, the formal presentations were about housing, subprime mortgages, and the dynamics of financial crises. In the second-floor hideaway that had become the Fed’s summer war room, Fed officials chewed over options for Fannie Mae and Freddie Mac.