Weak Fire Fighting Tools: Capital and Resolution
- No Treasury, FDIC, or Fed authority to inject capital
- FDIC could safely wind down failing banks but could not wind down complex banks or shadow banks
Weak Fire Fighting Tools: Liquidity
- Discount window lending to commercial banks
- 13(3) authority to lend to non banks in “unusual and exigent circumstances”
- No authority to purchase financial assets other than Treasuries and Agencies
Weak Fire Fighting Tools: Guarantees
- FDIC-insured deposits up to $100k
- Deposits above $100k, business transaction accounts, foreign deposits, repo, commercial paper for banks
- Any liabilities of shadow banks
- FDIC’s systemic risk exception
- Treasury’s Exchange Stabilization Fund
“On the eve of the crisis, our financial capacity was strong, but our firefighting tools were weak.”
- The reality of operating in extreme uncertainty
- Hard to know what works; a lot of it is about confidence
- We were living with the constant and acute fear that the crisis would get away from us
- Our strategy was ultimately to decide to do too much, rather than risk doing too little
The Framework for Crisis Resolution
- Stimulus large relative to fall in private demand Quick and sustained
- Negative real rates
- Sustained to help facilitate deleveraging
- Classic lender of last resort provision of liquidity
- Support for funding markets
- Resolution and restructuring
What We Did: Letting it Burn
- Standard monetary policy: lowered interest rates aggressively
- Tried to get liquidity into the banking system by reducing the stigma of the discount window
- Liquidity swaps for foreign central banks
- Fiscal stimulus through modest tax rebates…
- But didn’t lend beyond banks
- We did not step in to finance the securities the market didn’t want to finance
- And we allowed the weaker non-banks to fail
- More than two dozen mortgage lenders failed, including New Century in April 2007
What We Did: Early Escalation
- Broke the line past banks—lent directly to nonbanks PDCF, TSLF, Bear Stearns
- Went to Congress for Fannie/Freddie bazooka, prepared for war
All this helped slow the burn
What We Did: Breaking the Panic
- Dramatically expanded liquidity into critical markets (CP and ABCP) and shadow institutions
- Provided additional support to systemic institutions: AIG, Citigroup, and Bank of America
- Provided guarantees to $3.4 trillion money fund industry and the entire banking system
- Injected capital into more than half of the banking system by assets
- Deployed unlimited central bank swap lines to support the global system
- Provided bridge financing to major auto companies
Triage in a Panic
- How do you decide which firms to save and which to allow to fail?
- How should you balance concerns about moral hazard with the risk of accelerating a run on the financial system?
- When should you impose haircuts on bank creditors and when should you guarantee them?
From Lehman to AIG to WaMu
In a period of four weeks in September 2008, the United States:
- Put Fannie and Freddie into conservatorship, guaranteeing their creditors but forcing their equity holders to absorb losses.
- Helped encourage the acquisition of a failing investment bank (Merrill Lynch) by Bank of America.
- Failed to find a buyer for Lehman Brothers, another failing investment bank.
- Acted to prevent the failure of a large global insurance company, AIG.
Imposed losses on the creditors of a large failing bank (WaMu) in the context of facilitating its merger with JP Morgan.The pressures that brought all these firms to the brink of collapse were symptoms of the broader financial panic and deepening recession. But the losses imposed on Lehman’s and then WaMu’s creditors accelerated the panic, dramatically intensifying the crisis.
Fog of War, Moral Hazard, Politics
- Why such a disparate, inconsistent, seemingly erratic response?
- Was it fog of war, concern about moral hazard, fear of political opposition, lack of appreciation for the fragility of the financial system, lack of creativity, limitations on authority?
Mostly it was the limitations of authority
- The Fed could not lend to an institution that was not a bank, except under limiting conditions
- In the absence of a willing buyer, the Fed did not have the authority to lend on a scale that would save Lehman. Just like we did not have the authority to save Bear on our own.
- AIG, in contrast, had businesses of sufficient value that we could lend on a scale to prevent its collapse.
Haircuts and Runs
- FDIC had emergency authority that allowed it to guarantee the creditors of a bank
- In the case of WaMu, however, the FDIC chose not to use that authority
- This added fuel to the fire, accelerating the panic, and spreading it to the broader banking system
The FDIC, to its credit, reversed course weeks later by:
- Facilitating a solution to Wachovia’s problems that would have protected its creditors
- Agreeing to guarantee new borrowing by bank holding companies
If you haircut creditors in a systemic panic, when all firms look vulnerable, you risk intensifying the crisis, and forcing broader interventions to prevent the collapse of the financial system
Resolution: What We Did
- Powell doctrine to revive growth—fiscal, monetary, financial
- $800 billion fiscal stimulus
- Continued monetary stimulus: zero bound and quantitative easing
- Coordinated global Keynesian response
- Stress test to restore confidence and recapitalize the system
- Expanded scope of backstop to credit markets
- Hardened the guarantee of the banking system (BHCs and GSEs too)
The Stress Test: How and Why Did It Work?
- Transparency, firm by firm, about losses in the extreme event.
- Device for triage, for determining nationalization.
- Tool for recapitalizing the financial system.
- Helped maximize the chance that capital would come from the private sector.
The Stress Test Calmed Fears of Catastrophic Failure
Why did it work?
- Loss estimates were credible.
- We hardened the guarantees on liabilities.
- Fiscal and monetary policy escalation got traction.
Confidence improved by global cooperation and massive mobilization of dollar-based financial support for EM.
“We put enough money in the window.”
- Escalated slowly and messily
- Eventually moved to overwhelming force
- That wasn’t enough to prevent massive economic damage
- Felt like a long time—but in the arc of history, we put out the financial fire and restored economic growth remarkably quickly
- In some ways, did the opposite of the policy strategy in the Great Depression
- Avoided “Sweden” (full nationalization) and “Japan” (drift and forebearance)
What Went Wrong? Home prices skyrocketed, people borrowed more than they could afford, and then millions lost their jobs
By the fall of 2009, nearly 9 million Americans lost their jobs and 1 in 5 mortgages were underwater; 2 million mortgages were in foreclosure, and another 7 million were at serious risk of foreclosure
Key Policy Constraints
We Could Not
- Discharge homeowner debt in bankruptcy—“cramdown” legislation failed twice
- Create a “Home Owners’ Loan Corporation”—exceptionally complicated and Congressional action was needed
- Start another mortgage refinancing program—again, required legislation Undertake widespread mortgage debt forgiveness— Administration pursued targeted “principal reduction” but we couldn’t force FHFA to use its authority
We needed greater resources and authority to alleviate the pain of homeowners
Special thanks to Timothy F. Geithner (Lecturer in Management, Yale SOM, Former U.S. Secretary of the Treasury, Yale School of Management) and Andrew Metrick (Michael H. Jordan Professor of Finance and Management, Yale School of Management)