Stress Test
Copyright © 2014 by Timothy F. Geithner
All rights reserved.
Published in the United States by Crown Publishers, an imprint of the Crown Publishing Group, a division of Random House LLC, a Penguin Random House Company, New York.
www.crownpublishing.com
CROWN and the Crown colophon are registered trademarks of Random House LLC.
Cataloging-in-Publication Data is on file with the Library of Congress.
ISBN 978-0-8041-3859-8
eBook ISBN 978-0-8041-3860-4
Jacket design: Christopher Brand
Jacket photograph: Brooks Kraft
Charts: Joe LeMonnier
v3.1
For the intrepid public servants at the Treasury and the Federal Reserve who worked with great skill and devotion to help guide their country through the crisis
CONTENTS
Cover
Title Page
Copyright
Dedication
INTRODUCTION: The Bombs
ONE: An American Abroad
TWO: An Education in Crisis
THREE: Leaning Against the Wind
FOUR: Letting It Burn
FIVE: The Fall
SIX: “We’re Going to Fix This”
SEVEN: Into the Fire
EIGHT: Plan Beats No Plan
NINE: Getting Better, Feeling Worse
TEN: The Fight for Reform
ELEVEN: Aftershocks
EPILOGUE: Reflections on Financial Crises
TRIBUTE TO THE CRISIS TEAM
Photo Insert
ACKNOWLEDGMENTS
AUTHOR’S NOTE
NOTES
INTRODUCTION
The Bombs
On the morning of January 27, 2009, my first full day as secretary of the Treasury, I met with President Barack Obama in the Oval Office. The worst financial crisis since the Great Depression was still raging, and he wanted to put out the fire for good. The banking system was broken. The broader economy was contracting at a Depression-level rate. Consumer confidence had sunk to an all-time low, and millions more Americans were in danger of losing their jobs, their savings, even their homes. The President looked calm and reasonably comfortable after a week in the White House, despite all the bad news he was getting.
I was about to give him some more.
First, I thanked him for coming to my swearing-in the night before, a nice gesture of personal confidence in me. We had met just three months earlier, and I was in many ways an unorthodox choice to lead Treasury. I wasn’t a banker, an economist, a politician, or even a Democrat. I was a registered independent without much of a public profile—and the profile I had didn’t exactly signal Obama-style hope and change. As head of the Federal Reserve Bank of New York, I had spent the past year working with a Republican Fed chairman, Ben Bernanke, and a Republican Treasury secretary, Henry Paulson, Jr., to design a series of spectacularly unpopular rescues of financial firms. I didn’t look like a Treasury secretary, either. I was forty-seven. I lacked gray-haired gravitas. Barney Frank, one of my closest allies in Congress, later observed that when I spoke in public, I looked like I was at my own bar mitzvah.
And I was already politically damaged goods. I had been portrayed throughout my confirmation hearings as a tax cheat, a tool of Wall Street, an enemy of Main Street. Even though I had spent the previous two decades in public service, I was routinely described as a venal investment banker. Some thought I might be the first Treasury nominee rejected since before the Civil War, and I had considered withdrawing before the vote. I was eventually confirmed, by the narrowest margin since World War II; I already felt crushing guilt about the humiliation I was forcing on my family, and the political capital the President had to spend on me.
But now it was time to get to work. I took a seat on a sofa facing away from the Rose Garden, the seat I would take hundreds of times over the next four years. The President sat in his official chair to my right. On the couch across from me was the renowned economist Larry Summers, a former Treasury secretary who had met me when I was a junior civil servant in the department and had helped promote me up the ranks. Now Larry was running the President’s National Economic Council, so we would fight the crisis together. It should have been an exciting moment for me—a career technocrat entering the epicenter of power, alongside a brilliant former boss and an inspiring new president.
It didn’t feel exciting. It felt dark and daunting.
I had spent much of my career dealing with financial crises—in Mexico, Thailand, Indonesia, Korea, and beyond—but this was the big one, the hundred-year storm. Bernanke, Paulson, and I had already engineered a series of emergency interventions for a variety of financial giants, culminating in the Troubled Asset Relief Program (TARP), a $700 billion intervention for the entire financial system. But we hadn’t ended the crisis. The index measuring the risk of corporate defaults was even higher than it had been after the chaotic collapse of the Lehman Brothers investment bank in September 2008, when stock markets crashed, bond markets went haywire, and even supposedly safe money market funds were overwhelmed. Foreclosures were at an all-time high. The economy was shedding more than 750,000 jobs a month.
We had slowed the post-Lehman panic, but the financial system was still frozen. Banks that had overextended themselves during the boom were now in defensive retreats, hoarding cash, depriving businesses of financial oxygen. There was virtually no private credit available for ordinary borrowers who wanted to finance a new car or a college education, much less a new home. We had slipped into a vicious cycle, as the financial earthquake began to ripple through the broader economy. As laid-off workers and other nervous consumers spent less, businesses were laying off more workers and investing less, prompting families and businesses to cut back even more. The crippled financial system was making the recession worse, while the deepening recession was making the financial system worse. Wall Street and Main Street were going down together. I had recently started reading Liaquat Ahamed’s Lords of Finance, a history of the policymakers whose mistakes helped create and prolong the Great Depression, but I had put it down after a few chapters. It was too scary.
The President knew he couldn’t fix the broader economy without fixing the financial system. Banks are like the economy’s circulatory system, as vital to its everyday functioning as the power grid. No economy can grow without a financial system that works, safeguarding the savings of individuals, moving money where it’s needed, helping families and businesses invest in their futures. And ours was still a mess.
“Now that I’m official, I can tell you how bad it really is,” I said.
FOR STARTERS, I told the President, we still had five “financial bombs” to defuse.
By bombs, I meant huge, far-flung, overleveraged institutions whose failure could spark the kind of global panic the Lehman bankruptcy had sparked in the fall. I listed them: Fannie Mae, Freddie Mac, AIG, Citigroup, and Bank of America. They all were much larger than Lehman. All five had received major infusions of government cash to save them from failure; AIG had been rescued three times in four months. But they all were in trouble again, and we needed to make sure they didn’t explode—not to protect them from the consequences of their mistakes, but to prevent another messy failure from ravaging the rest of the economy. The politics would be awful. People hated the idea of government bailouts for mismanaged financial behemoths. But if their creditors or the markets in general lost confidence that any of them could meet their obligations, we’d be looking at a worldwide financial meltdown, and a much deeper economic crisis.
Fannie and Freddie, the Washington-based housing giants that backed most U.S. mortgages, needed the most help. They were quickly burning through nearly $200 billion in taxpayer aid, and wi
thout another $200 billion or so—the equivalent of more than three years’ worth of federal education department spending—they risked catastrophic defaults. Even a modest increase in that risk would push mortgage rates higher and home prices lower, intensifying the recession.
AIG was the closest to exploding, and the most egregious financial basket case. But while the century-old insurer had become a three-letter symbol of excessive risk, AIG also had tens of millions of innocent policyholders and pensioners who depended on it, plus tens of thousands of derivatives contracts with businesses around the world. A default on its debts or even a downgrade of its credit rating would reignite the panic.
Citi and Bank of America were the biggest of the bombs, Exhibits A and B for the outrage over “too big to fail” banks; my aides called them the Financial Death Stars. But the world was so fragile, and they really were so big, that if we didn’t want a reprise of the Depression—an obliterated banking sector, 25 percent unemployment, thousands of businesses shuttered—we had to make sure they didn’t drag down the system, even if it looked like we were rewarding the reckless.
That was a lot to dump on a new president’s plate. But the problem was bigger than the bombs.
We weren’t just dealing with five severely undercapitalized firms that could blow up the financial system. We were dealing with a severely undercapitalized system. Even after the TARP investments and our other emergency assistance, it did not have enough capital to cover its potential losses, much less finance an economic recovery. And Larry and I were concerned that our new administration didn’t have enough cash—or enough authority—to repair it.
My former New York Fed colleagues had privately calculated that the banking sector alone might need another $290 billion to survive a bad recession, and as much as $684 billion to survive an “extreme stress scenario.” Those numbers didn’t include the potential cost of stabilizing “nonbank” financial institutions such as AIG. They didn’t include the potential cost of rescuing General Motors and Chrysler, which were also on the verge of bankruptcy. And we had only about $300 billion left in uncommitted TARP funds.
Larry and I told the President we might have to ask for another TARP, at a time when Congress had zero interest in more bailouts.
I couldn’t claim I knew exactly what would work. There hadn’t been a crisis this severe in seventy-five years, and never in a financial system this complex. Repairing our banks and other financial institutions, while necessary, would not be sufficient to fix the economy. That’s why the President was already pushing a massive fiscal stimulus bill—$800 billion in government spending and tax cuts—to offset lost income and wealth, revive demand, and create jobs. The Fed was also expanding the frontiers of stimulus through monetary policy. Financial rescue, fiscal stimulus, and monetary stimulus—along with the President’s efforts to prop up the beleaguered auto and housing sectors—would all have to work together, if they were to work at all.
But stabilizing the financial system was our most immediate problem. A renewed banking panic would quickly overwhelm any fiscal and monetary support we could provide. Larry and I were convinced we had to try to get ahead of the crisis, instead of continuing to chase it from behind. We told the President we had to err on the side of doing too much, even though the public thought we were already doing too much. In an emergency, temporizing half-measures would be riskier than overwhelming force, and ultimately more expensive for taxpayers—not only in dollars, but in lost jobs, failed businesses, and foreclosed homes.
The President took all this in quietly, patiently, seemingly unfazed. His instinct was to move quickly to repair and restructure the entire financial system, not to let it limp along or sweep its problems under the rug. He wanted to be aggressive and comprehensive.
“We need to rip the Band-Aid off,” he said. “I want to do this right, and get it over with.”
I agreed, but with a qualification. There was intense pressure on us to punish the Wall Street gamblers who had gotten us into this mess—to nationalize or liquidate floundering firms, or force bondholders to accept “haircuts” rather than the face value of their bonds. Those get-tough actions would feel resolute and righteous, but in a time of uncertainty, they would damage confidence and accelerate the downward spiral. As we had seen in the panic of the fall, that would hurt Main Street, not just Wall Street. We wanted to avoid the long, sideways drift that Japan had experienced after its crisis in the 1990s, but also the trauma of another Great Depression.
“We do have to rip the Band-Aid off,” I said. “But we have to make sure we don’t break the financial system.”
The President wasn’t sure what I meant, so Larry translated: “What Tim means is, we can’t afford a plan that shatters a fragile system, destroys confidence, and causes the stock market to crash.”
The President’s charge was direct and forceful: Come back soon with a plan to clean up this mess. He wanted to do the hard stuff early, take the pain quickly. “Leave the politics to me,” he said. Just focus on the substance, what will work best, how to restore confidence. He understood the inherent uncertainty we faced, the real possibility that reasonable decisions would produce horrible results, the absence of a perfect or even an attractive option. He made it clear he was willing to take serious risks to try to get this nightmare behind us.
I was impressed. But I didn’t feel very confident.
EVERY FINANCIAL crisis is a crisis of confidence.
Financial systems, after all, are built on belief. That’s why the word credit is derived from the Latin for believe, why we say we can “bank” on things we believe true, why financial institutions often call themselves “trusts.” Think about how a traditional bank worked. Depositors entrusted it with their money, confident it could repay them with interest at any time. The bank then lent out their money at a higher interest rate, confident that everyone wouldn’t want their money back at the same time. But when people lost confidence in a bank—sometimes because of rational concerns about its lending or leadership, sometimes not—they would all want their money back at the same time. The result was a run on the bank, like the famous scene in It’s a Wonderful Life when depositors rush to pull their money out of a Depression-era savings and loan. Confidence is a fragile thing. When it evaporates, it usually evaporates quickly. And it’s hard to get back once it’s lost.
A financial crisis is a bank run writ large, a run on an entire financial system. People lose confidence that their money is safe—whether they’re stockholders or bondholders, institutional investors or elderly widows—so they rush to pull it out of the system, which makes the money remaining in the system even less safe, which makes everyone even less confident. This has happened a lot throughout history, in rich countries and poor ones, in sophisticated systems and simple ones. Human beings are prone to panics, just as we are prone to the kind of irrational confidence (in real estate, or stocks, or seventeenth-century Dutch tulips) that produces the booms that precede panics. And once the stampede begins, it becomes rational for individuals to join it to avoid getting trampled, even though their collective actions are irrational for society as a whole. These panics almost always have brutal consequences—for teachers and construction workers, not just investors and bankers—and policymakers almost always make them worse.
The question facing us in early 2009 was: How can the government restore confidence during a crisis? Part of the answer, while distasteful, was simple. The government can stand behind faltering firms, removing the incentives that turn fear into panic. Banks under siege used to stack money in their windows to reassure depositors there was no need to run; when governments put enough “money in the window,” they can reduce the danger they’ll have to use it. The classic example is deposit insurance, Franklin Delano Roosevelt’s response to Depression-era bank runs. Since 1934, the government has guaranteed deposits at banks, so insured depositors who get worried that their bank has problems no longer have an incentive to yank out their money and make the proble
ms worse.
Of course, the banking system that FDR inherited didn’t have “collateralized debt obligations,” “asset-backed commercial paper,” or other complexities of twenty-first-century finance. In the panic of 2008, insured bank deposits didn’t run on any significant scale, but all kinds of other frightened money did—and in the digital age, a run doesn’t require any physical running, just a phone call or a click of a mouse. By early 2009, the government had put a lot of money in the window through TARP and other emergency measures. We had backstopped tens of trillions of dollars’ worth of financial liabilities. But the financial system was still paralyzed. The markets could see the five bombs. And our crisis response had seemed so inconsistent, with so many policy zigzags and unexpected lurches, that investors and creditors were uncertain we had the capacity and the will to finish the job. Uncertainty is also at the heart of all financial crises. They simply don’t end without governments assuming risks that private investors won’t, taking catastrophe off the table.
The obvious objection to government help for troubled firms was that it rewarded the arsonists who set the system on fire. This objection took two forms. One was a moral argument about justice, what I called the “Old Testament view.” The venal should be punished. The irresponsible shouldn’t be bailed out. The other was an economic argument about incentives, the “moral hazard” critique. If you protect risk-takers from losses today, they’ll take too many risks tomorrow, creating new crises in the future. If you rescue pyromaniacs, you’ll end up with more fires.
Those are valid concerns. And in most states of the world, they’re sensible guides for action. During a typical recession or even a limited crisis, firms should face the consequences of their mistakes, and so should the investors who lend them money. But trying to mete out punishment to perpetrators during a genuinely systemic crisis—by letting major firms fail or forcing senior creditors to accept haircuts—can pour gasoline on the fire. It can signal that more failures and haircuts are coming, encouraging creditors to take their money and run. It can endanger strong as well as weak institutions, because in a stampede, the herd can’t tell the difference; that’s basically the definition of a financial crisis. Old Testament vengeance appeals to the populist fury of the moment, but the truly moral thing to do during a raging financial inferno is to put it out. The goal should be to protect the innocent, even if some of the arsonists escape their full measure of justice.