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)
You might have missed the latest bank scandal, the one involving Barclays Plc (BARC), in the hubbub of last week’s U.S. health-care ruling and euro salvage plan.
If so, allow us to fill you in: On June 27, Barclays, the U.K.’s second-largest bank by assets, admitted it deliberately reported artificial borrowing costs from 2005 to 2009. The false reports were used to set a benchmark rate, the London interbank offered rate, or Libor, which affects the value of trillions of dollars of derivatives contracts, mortgages and consumer loans. The bank agreed to pay a hefty $455 million to settle charges with U.S. and U.K. regulators, and on Monday its chairman resigned.
Earlier today, Robert Diamond resigned as chief executive officer. Marcus Agius, who yesterday said he would resign as chairman, reversed his decision after Diamond quit and will stay on to lead the search for a new CEO. In an apology to employees before he stepped down, Diamond wrote that some of the misconduct occurred on his watch, when he was head of Barclays Capital, the investment-banking unit. Diamond was already in the doghouse with investors. In April, 27 percent of shareholders, upset that Barclays had missed profit targets, voted down his $19.5 million pay package.
Heads should roll at other banks, too. Regulators and criminal prosecutors, including the U.S. Justice Department, are investigating at least a dozen other firms to determine whether they colluded to rig the rate. Among them: Citigroup Inc., Deutsche Bank AG, HSBC Holdings Plc and UBS AG.
We don’t countenance bank bashing. Nor have we ever called on regulators to bust up big banks. But it’s difficult to defend an industry that defrauds the market with fake interest-rate figures, thereby stealing from other banks and customers.
Sadly, the Libor case reveals something rotten in today’s banking culture. We hope the investigations expose the bad actors, lead to jail terms for those who knowingly manipulated the market, and force out the senior managers and board directors who participated in, or overlooked, such conduct.
Why so exercised? In the Barclays settlement documents, regulators released smoking-gun e-mails that reveal the extent of the dirty dealing between bank traders (looking to protect profits and bonuses) and senior officials in bank treasury units (hoping to convince markets that their banks weren’t in financial difficulty). The two aren’t supposed to collude, but it’s obvious that the Chinese walls between them come with ladders.
Libor and its euro counterpart, the Euribor, are benchmark rates determined by bank estimates of how much it would cost them to borrow from one another, in different timeframes and currencies. The banks submit sheets of numbers every weekday morning, London time. An adjusted average of the rates determines the size of payments on mortgages and corporate loans worldwide. The rates also serve as an indicator of the health of the banking system. Because some submissions aren’t based on real trades, the potential exists for manipulation.
A Barclays banker responsible for reporting borrowing rates was told to make the bank look healthier by not revealing that borrowing costs had risen. An e-mail he wrote to a supervisor confirms that he complied: “I will reluctantly, gradually and artificially get my libors in line with the rest of the contributors as requested,” he wrote. “I will be contributing rates which are nowhere near the clearing rates for unsecured cash and therefore will not be posting honest prices,” he continued, referring to rates in the overnight money market.
At times, Barclays traders sought to affect rates on dates when interest-rate derivatives contracts settled, thus profiting more from trades, according to documents made public by the U.S. Commodity Futures Trading Commission, one of the agencies conducting the Libor probes. Here’s an e-mail about the three- month rate from a senior Barclays trader in New Yorkto the London banker who submitted the rates: “Hi Guys, We got a big position in 3m libor for the next 3 days. Can we please keep the lib or fixing at 5.39 for the next few days. It would really help. We do not want it to fix any higher than that. Tks a lot.”
Bankers submitting rates responded to such requests as if they were routine: “For you, anything,” and “done … for you big boy,” according to the e-mails. Not that the efforts went unappreciated: “Dude. I owe you big time!” one trader wrote to a Libor submitter. “Come over one day after work and I’m opening a bottle of Bollinger.”
Barclays traders also coordinated with counterparts from other banks. In an instant message, one Barclays trader wrote to a trader at another bank: “If you know how to keep a secret I’ll bring you in on it, we’re going to push the cash downwards. … I know my treasury’s firepower … please keep it to yourself otherwise it won’t work.”
The Libor system, overseen by the British Bankers Association, operates much the way it did in the 1980s. Even after the news media uncovered evidence of manipulation in 2008, the bank lobby did little to reduce conflicts or improve the veracity of its numbers. The best solution, as Bloomberg View has advocated, is to end Libor and create a benchmark using data from actual loans, rather than relying on banks to tell the truth about their borrowing costs.
The real tragedy of the scandal is the apparent lack of ethics or self-restraint among the people involved. Following billions of dollars of trading losses at JPMorgan Chase & Co.’s out-of-control London unit, the latest installment of big-bank follies offers yet more proof that the industry shouldn’t be trusted to regulate itself.
Deutsche Bank AG, Germany’s largest bank, said profit fell 76 percent in the fourth quarter as Europe’s sovereign-debt crisis curbed trading and the company booked writedowns on holdings.
Net income fell to 147 million euros ($194 million) from 601 million euros a year earlier, the Frankfurt-based company said today in astatement. That missed the 556 million-euro average estimate of 12 analysts surveyed by Bloomberg. The investment bank had a 422 million-euro pretax loss.
Chief Executive Officer Josef Ackermann, who is delivering full-year results for the last time before stepping down at the end of May, was forced to abandon his goal of posting record profit last year as clients shied from trades amid the debt crisis. Deutsche Bank also took charges on litigation, Greek government bonds, Icelandic generic drug maker Actavis Group hf, a Las Vegas casino and its BHF-Bank AG unit in the fourth quarter, according to the statement.
“You can’t be optimistic given the market environment,” Olaf Kayser, an analyst with Landesbank Baden-Wuerttemberg who recommends investors buy the stock, said before the results were published. “The client activity just isn’t there, you can see it from the number of transactions falling.”
“Broadly the situation has improved, particularly the one in Europe,” Jain, the 49-year-old head of the investment bank, told Bloomberg Television’s Erik Schatzker in Davos, Switzerland, on Jan. 26. “But look, the possibility of a tail event continues to hang over us.” Until that changes, “high volatility is the new norm, and one we’ll all need to just live with,” he said.
Deutsche Bank advanced 21 percent in Frankfurt trading since the European Central Bank said Dec. 8 it would offer unlimited three-year loans to lenders — a decision Ackermann described to CNBC as important in easing some of the banking system’s “funding challenges.” Bloomberg’s 43-company European banks index climbed 15 percent in the period.
New York-based JPMorgan Chase & Co., the biggest U.S. bank by assets, posted a 23 percent decline in profit on lower investment-banking fees and revenue from trading stocks and bonds. Earnings at Goldman Sachs Group Inc., also based in New York, dropped 58 percent, leading the firm to cut compensation in response to falling revenue. Among the five largest Wall Street banks, only Morgan Stanley posted an increase in trading income, excluding accounting gains, in 2011.
Deutsche Bank scrapped in November its operating pretax profit forecast of 10 billion euros for 2011 and announced 500 job cuts amid a “significant and unabated slowdown in client activity.” Ackermann’s purchase of Deutsche Postbank AG and Sal. Oppenheim Group to build up consumer-banking and wealth- management have failed to make up for lower investment banking.
The investment bank’s loss compared to a 603 million-euro pretax profit a year earlier and the 233 million-euro profit estimate from nine analysts. Revenue from debt trading dropped to 1.04 billion euros from 1.61 billion euros, missing the 1.47 billion-euro estimate, while equity trading revenue decreased to 539 million euros from 872 million euros, beating the 457 million-euro analyst survey.
Deutsche Bank booked costs of 380 million euros at the investment bank related to litigation and 154 million euros for U.K. and German bank levies.
Deutsche Bank consolidated the results of Postbank in December 2010, a purchase that followed the acquisitions of private-wealth manager Sal. Oppenheim and ABN Amro Holding NV’s commercial-banking operations in the Netherlands, as Ackermann added businesses with more predictable profits than investment banking.
Pretax earnings at the consumer banking unit climbed to 227 million euros from 222 million euros, missing the 384 million- euro average estimate in the analyst survey. The bank took charges on Greek bonds held at Postbank. Profit from the asset and wealth management business rose to 165 million euros, lower than the 180 million-euro estimate.
Deutsche Bank cited a “more challenging market environment” at the asset and wealth management division.
The company has been a “big winner” in taking market share from rivals, Jain said in the interview, and there’s an opportunity for more gains as changes in the industry, including tougher capital rules and a restriction on business models, create a “winnowing out” among financial firms.
European leaders are demanding that some of the region’s largest banks increase reserves after financial firms agreed to accept losses on Greek debt to help rescue the country. Deutsche Bank was among six German banks told to raise a total of 13.1 billion euros to boost core Tier 1 capital as a ratio of risk- weighted assets to 9 percent or more by June 30, after writing down the value of sovereign bonds.
The company said Dec. 8 that it expected to plug the 3.2 billion-euro gap calculated by the European Banking Authority six months early, without saying how it will meet the goal.
The German firm in November announced a strategic review of its global asset-management division, excluding operations of the DWS mutual fund unit in Germany, Europe and Asia. Executives decided last month to pursue a sale of the businesses, which have almost 400 billion euros in assets under management, according to two people with knowledge of the matter.
Analysts will be watching for any further signs the bank will change direction under its new leadership.
“It’s going to be exciting if strategic changes are announced,” said Kayser, the LBBW analyst. “The first steps are known, with the planned sale of asset-management operations.”
Deutsche Bank posted an impairment of 407 million euros related to Actavis, 97 million euros in expenses related to BHF- Bank and a 135 million-euro charge from the Cosmopolitan Resort & Casino in Las Vegas, which Deutsche Bank took over in 2008 when developer Ian Bruce Eichner defaulted on a loan. The writedowns contributed to a loss of 722 million euros at the corporate investments unit in the quarter.
The German lender took a 144 million-euro impairment charge on Greek bonds at its private clients and asset management unit, according to the statement.
Goldman Sachs & Co., a unit of the most profitable bank in Wall Street history, took $15 billion from the U.S. Federal Reserve on Dec. 9, 2008, the biggest single loan from a lending program whose details have been secret until today.
The program, which peaked at $80 billion in loans outstanding, was known as the Fed’s single-tranche open-market operations, or ST OMO. It made 28-day loans to units of 19 banks between March 7, 2008, and Dec. 30, 2008. Bloomberg reported on ST OMO in May, after the Fed released incomplete records on the program. In response to a subsequent Freedom of Information Act request for details, the central bank disclosed borrower names, amounts borrowed and interest rates.
ST OMO is the last known Fed crisis lending program to have its details made public. The central bank resisted previous FOIA requests on emergency lending for more than two years, disclosing details in March of its oldest loan facility, the discount window, only after the U.S. Supreme Court ruled it had to. When Congress mandated the December 2010 release of data on special initiatives the Fed created in its unprecedented $3.5 trillion response to the 2007-2009 collapse in credit markets, ST OMO — an expansion of a longstanding program — wasn’t included.
“The Fed has come a long way over a long period of time as far as transparency,” said Raymond W. Stone, managing director and economist with Stone & McCarthy Research Associates in Princeton, New Jersey. “They thought counterparties might be harmed, but now so much time has passed that the information is not as sensitive anymore.”
The 19 borrowers from the program are known as primary dealers, which are designated to trade government securities directly with Federal Reserve Bank of New York. They bid at auctions for ST OMO’s cash. While the rates they paid generally tracked the federal funds rate, the rate for some dipped as low as 0.01 percent in December 2008.
The New York Fed conducted 44 ST OMO auctions, according to its website. Banks bid the interest rate they were willing to pay for the loans and pledged mortgage-backed securities guaranteed by government-sponsored enterprises such as Fannie Mae or Freddie Mac as collateral for the Fed’s cash. The transactions were known as repurchase agreements, or repos.
ST OMO was an expansion of longstanding open-market operations, which offered cash for up to two weeks and were used as a tool of monetary policy. In March 2008, the Fed adapted the program to alleviate pressures in short-term credit markets, according to a news release the central bank issued at the time.
The program shouldn’t be grouped with the Fed’s other crisis lending initiatives because it was “not outside of the Fed’s standard authorities,” David E. Altig, senior vice president and director of research at the Federal Reserve Bank of Atlanta, said in his blog in May.
The New York Fed posted aggregate data about the program on its website after each auction, said Jeffrey Smith, a New York Fed spokesman. By increasing the availability of short-term financing when private lenders were under pressure, “this program helped alleviate strains in financial markets and support the flow of credit to U.S. households and businesses,” he said. All of the ST OMO loans were repaid.
Some primary dealers used the program to help customers, such as hedge funds, finance their holdings of mortgage-backed securities, Stone said.
“The Fed didn’t want to just finance the primary dealers, they wanted the mortgage-backed securities market to become more fluid,” Stone said.
Credit Suisse Securities USA LLC, a unit of Switzerland’s second-biggest bank, had $45 billion in loans outstanding on Aug. 27, 2008 — the largest peak borrowing amount, the data show.
“Credit Suisse was a net creditor throughout the crisis and made between $30 and $70 billion of liquidity available to central banks each day,” said Victoria Harmon, a spokeswoman for the bank in New York.
Six of the program’s top seven borrowers were units of foreign banks, the data show.
Goldman Sachs’s peak outstanding loans were the second- highest at $34.5 billion on Dec. 31, 2008, when interest rates were at their lowest, according to the data. Michael DuVally, a spokesman for New York-based Goldman Sachs Group Inc. (GS), the parent company of the primary dealer, declined to comment.
Lehman Brothers Inc. had two loans totaling $2 billion outstanding when its parent investment bank filed the biggest bankruptcy in U.S. history on Sept. 15, 2008, the data show. Those loans were repaid on Sept. 18, 2008, under a separate agreement, the Fed’s release said. Lehman’s peak borrowings from ST OMO reached $18 billion on June 25, 2008, according to the data.
Kimberly Macleod, a Lehman spokeswoman, didn’t immediately respond to an e-mail seeking comment.
RBS Securities Inc., a unit of Britain’s second-biggest bank by market capitalization, had $31.5 billion in loans outstanding on Oct. 8, 2008, and UBS Securities LLC, part of Switzerland’s biggest bank, borrowed as much as $20.5 billion on Nov. 26, 2008, the Fed said.
Among the smallest loans was one to Bear Stearns & Co., the primary-dealer unit of Bear Stearns Cos. The primary dealer took one loan from ST OMO for $500 million, on March 12, 2008, according to the release. JPMorgan Chase & Co. (JPM) bought the New York-based investment bank four days later. The loan was repaid on April 9, 2008, the data show.
The information on ST OMO is available on the central bank’s Web site: http://www.federalreserve.gov/monetarypolicy/bst_tranche.htm