Stress Test Read online

  My first reaction was to laugh, and ask: “How much do you know about me?” I gently pointed out that it seemed a bit early in my career for that job.

  The New York Fed, the government’s main outpost in America’s financial center, is the largest and most influential of the Federal Reserve’s twelve regional banks. Its president serves as vice chair of the Fed committee that sets monetary policy; its staff buys and sells government securities to implement monetary policy; it shares responsibility for supervising some of America’s biggest banks, including Citigroup, JPMorgan Chase, and Bank of New York Mellon. At the time, it was mostly unknown to the public—except for the seven thousand tons of gold in its basement, the stash Jeremy Irons tried to steal in the film Die Hard: With a Vengeance—but it was a venerable institution, and traditionally its leaders had been financial giants.

  Its first president, Benjamin Strong, Jr., a member of J. P. Morgan’s powerful inner circle, had been the dominant force at the Federal Reserve in its early years. Its recent presidents were also prominent financial statesmen: Bill McDonough, a former banker who had held the job for the previous decade and helped defuse the LTCM crisis; Jerry Corrigan, a gravelly-voiced, blunt-spoken economist who was a Goldman Sachs managing director; and the legendary Paul Volcker, my Dartmouth graduation speaker, a six-foot-seven former Chase Manhattan banker who had gone on to the Fed chairmanship and was considered the conscience of Wall Street. I was only forty-two, and I had never worked in the finance industry.

  Peterson’s first choice to lead the New York Fed, the former IMF deputy Stan Fischer—at the time a top Citigroup executive—had turned him down. Other potential candidates, including John Taylor, my replacement at Treasury, hadn’t found enough support on the board. So Larry Summers, who had become president of Harvard University, and Bob Rubin, who had also joined Citigroup, suggested Peterson reach out to me. Chairman Greenspan also supported my candidacy, although he told me he hadn’t realized during my time at Treasury that I wasn’t a PhD economist.

  Peterson was still worried that I looked too young to command a room, as he put it. But with his characteristic humility, Larry told Peterson I had been strong enough to stand up to him, which meant I was strong enough to run the New York Fed. He apparently found that persuasive. Some of his board members were concerned about the social aspects of the job; they even asked to interview Carole to gauge her suitability as a first lady, a request I politely declined. Previous presidents had joined all kinds of civic groups and attended frequent Manhattan receptions. I told the board I preferred spending evenings at home with Carole and the kids, but I’d show up around town when necessary.

  I guess the board was OK with that, because they asked me to take the job. My family was less OK. Our twelve-year-old, Elise, burst into tears when I told her we were moving to New York; she said I was ruining her life and her mother’s career. Nine-year-old Ben didn’t seem as troubled, but he was generally less vocal than his sister. Carole was supportive but not thrilled. She would have to close her therapy practice and leave the George Washington University Medical School, where she was teaching listening skills to future doctors. And she had understandable reservations about the disruptions to all our lives. I had reservations, too. I would have to commute between Washington and New York until the end of the school year, and I knew Carole would bear most of the burden of the transition. But she was willing to make the sacrifice—“if you really want to do it,” she said—so I was able to accept the job.

  Once again, I felt intimidated by how much I had to learn. The Fed played a central role in responding to financial crises, and although I may have already been “baptized by fire,” as one of Peterson’s advisers for the search process told the New York Times, this job came with a much greater level of responsibility. And I didn’t have much experience with the rest of the Fed’s work. I had never supervised or regulated banks or markets. I hadn’t thought much about monetary policy, either; I doubted I could offer much help on that front to Greenspan, who was regarded at the time as a monetary maestro.

  I also understood why people questioned my gravitas; another one of those gag suggestions for my post-Treasury job had been star of a sequel about the teen doctor Doogie Howser. The night before I started at the New York Fed, I stopped at a convenience store to pick up yogurt, milk, beer, and other basics for my one-bedroom apartment on the Upper East Side.

  I got carded.

  I CAME to the New York Fed as an outsider, and I didn’t bring any of my own people with me to try to change it. I wanted to show respect for the institution, figure out how it worked, learn its strengths and weaknesses. It already had a solid reputation for being knowledgeable and sophisticated about financial markets, though some considered it a bit too close to those markets.

  The Fed’s twenty-two-story building at 33 Liberty Street, a sand-stone-and-limestone throwback to the banking houses of the Italian Renaissance, sits just a few blocks from Wall Street, in the shadows of the modern skyscrapers of the world’s major financial firms. My initial impression was that it was a bit musty with tradition and heavy on hierarchy. The walls were thick, the atmosphere dark, the daily rhythm slow and comfortable. The top ten senior officials all had spacious offices on a wood-paneled executive floor, separated from their teams on lower floors and across the street. It was exceedingly quiet up there. Oil paintings of my predecessors hung on the walls of an ornate boardroom named for Paul Volcker. And there were some weird formalities. During the day, coffee was brought to my desk on a silver tray. The first time I hosted a dinner at the New York Fed, I was served first while my guests watched. A buzzer was placed in front of me in case I needed to summon the staff. I would eventually change or eliminate many of these staid traditions, starting with the buzzer.

  My initial briefings were awkwardly formal, too. Typically, a senior executive would spend almost the entire time presenting a deck of PowerPoint slides, leaving only a few minutes for me to ask questions. Junior staffers seemed hesitant to speak. I met plenty of smart and competent people, but the meetings were not designed to promote debate or discussion, much less decisions by a new president with no history at the institution or experience in the field.

  I developed a lot of respect for the bank’s senior leaders, but I also began to reach out to talented staffers I found lower on the organizational chart. I asked that every memo submitted to me include the phone numbers of the staffers who drafted it, so I could call them directly with questions. And I began to change the expectations around meetings, asking everyone to read the slides and papers in advance so we could spend our time debating substance. I made it clear I expected everyone to say what they thought, regardless of how junior they were, regardless of the prevailing view in the upper hierarchy of the Fed in New York or Washington.

  This was a time when things seemed to be going pretty well in the American financial system. The U.S. economy was recovering from a mild recession, after weathering a series of financial disturbances with relative ease—the global crises of the 1990s, the demise of LTCM, the dot-com bust, the September 11 attacks, and a rash of accounting scandals that took down Enron and Arthur Andersen. Growth and confidence were getting stronger. Inflation was low. Credit was cheap and widely available. The banks under New York Fed supervision showed no signs of distress; on the contrary, they were enjoying their biggest profits in decades. They had high levels of capital, so they seemed well-positioned in case the good times stopped rolling.

  At the Fed in Washington, at the time, there was little apparent concern about the stability of the financial system. In New York, with some exceptions, there was also a general sense that things were under control. The bank supervisors had a pretty good record, although you could argue that with the banks thriving, they were like the old Maytag repairmen who didn’t have much to fix. When I started, there was a lot of understandable focus on fighting the last war, prioritizing post–September 11 issues such as hardening market infrastructure to survive terror a
ttacks. Bank supervisors were consumed with compliance issues, making sure rogue states didn’t park cash in American institutions and lenders didn’t violate antidiscrimination laws. One former New York Fed board member, Bob Wilmers of M&T Bank, once told me that 70 percent of his bank’s examination process involved anti-money-laundering and consumer protection.

  Those were important issues, but they seemed to be eclipsing more subjective and challenging systemic questions, such as whether banks were adequately managing their risks and retaining enough capital and liquidity to survive a crisis. In those days, systemic risk—the vulnerability of the financial system to a severe crisis—wasn’t prominent on the national radar screen. In fact, economists were starting to debate whether America’s long stretch of stability constituted a new normal, a Great Moderation, a quasi-permanent era of resilience to shocks. There was growing confidence that derivatives and other financial innovations designed to hedge and distribute risk—along with better monetary policy to respond to downturns and better technology to smooth out inventory cycles—had made devastating crises a thing of the past.

  I did not share that confidence. I had no particular knowledge or insight into whether the new financial innovations were stabilizing or destabilizing, but I was reflexively skeptical of excess conviction in any form, especially excess optimism. My dominant professional experiences had involved financial failures. I had seen during the emerging-market crises of the previous decade how long periods of stability and growth could breed instability and disaster. Confidence had always been an evanescent thing, and in this new age of mobile capital, trauma in one part of the world or one corner of the financial system could spread quickly. I didn’t see how a few years of calm or some clever financial innovations would cure the basic human tendency toward mania and self-delusion. History suggests that financial crises are usually preceded by proclamations that crises are a thing of the past.

  In my very first public speech at the New York Fed in March 2004, I tried to push back against complacency, telling a room full of bankers that the wonders of the new financial world would not necessarily prevent catastrophic failures of major institutions, and should not inspire delusions of safety on Wall Street. I even cited my favorite theorist on financial irrationality, the leading promoter of the idea that periodic financial crises are practically inevitable.

  “These improvements are unlikely to have brought an end to what Charles Kindleberger called ‘manias and panics,’ ” I said. “It is important that those of you who run financial institutions build in a sufficient cushion against adversity.”

  SO I started my new job with some generalized concern about the inherent vulnerability of financial systems to periodic crises. And I was troubled from the beginning by a more specific vulnerability of the U.S. system. The Fed was seen as America’s financial stability regulator, and the New York Fed was Washington’s best window into Wall Street, touching the markets every day. But our power to constrain risk in the financial system did not extend to the entire financial system. Our authority was disturbingly limited.

  The Fed shared responsibility for supervising commercial banks with insured deposits. And if one of those banks ran into liquidity problems, it could go to the Fed’s discount window for emergency loans that could help prevent a run. But as I started thinking about a potential crisis on my watch, one glaring danger stood out. Huge swaths of the financial system—investment banks, Fannie Mae and Freddie Mac, and many other large firms that behaved like banks without having to obey bank safety and soundness rules—were outside the Fed’s jurisdiction as well as the Fed’s safety net. These “nonbanks,” or “shadow banks,” were borrowing short and lending long, just like George Bailey’s bank or any other bank. But they were not subject to the capital requirements and other safeguards imposed on banks to limit risk, they did not have deposit insurance to prevent runs, and they would not be able to access the discount window if they faced runs. In that initial March 2004 speech, I suggested that financial innovation was driving risk and leverage into corners of the financial system with weaker supervision, and that our tools for monitoring systemic risk weren’t keeping up.

  Overall, more than half of America’s financial liabilities had migrated outside of banks and beyond the Fed’s direct purview. There’s nothing inherently dangerous about risk outside the traditional banking sector, unless the risk is concentrated in large bank-like entities with heavy leverage and short-term funding without bank-like regulations. But that’s exactly what had happened in the United States. This evolution in the structure of our financial system—the proliferation of risk in nonbank institutions that borrowed short and lent long just like banks—struck me as an overwhelmingly consequential problem for us as a financial stability regulator and a lender of last resort. I can’t say I had any idea what to do about it during my early days at the Fed. But as I had told Bob Rubin in another context, just because a problem didn’t have an obvious solution didn’t mean it wasn’t a problem. I knew that any financial crisis would end up at the New York Fed’s doorstep, whether it began in our jurisdiction or not.

  The Rise of “Shadow Banking”

  Financial Sector Liabilities

  The tremendous growth in financial sector credit from the 1980s through 2007 was almost entirely outside the traditional banking system. Risk consistently migrated to institutions that had fewer constraints than banks and did not have access to the government safety net.

  Source: Federal Reserve Board.

  In those early months, I often joked that being president of the New York Fed was like being the Wizard of Oz; my friend and former Treasury colleague Sheryl Sandberg, who had become a vice president at Google, used to call me the man behind the curtain. There was a widespread perception that we had awesome powers to fight financial fires, but when I studied our actual firefighting equipment—cataloged in a New York Fed binder known internally as “the Doomsday Book”—I was not particularly impressed.

  In addition to its monetary policy instruments, the Fed could lend to institutions that needed cash in a crisis—but only if they were commercial banks with insured deposits, and only if we thought they were fundamentally solvent, with their assets worth more than their liabilities. We did have additional authority in “unusual and exigent circumstances” through Section 13(3) of the Federal Reserve Act, but the Fed hadn’t invoked it since the Great Depression, and even that break-the-glass, only-in-extremis power was severely constrained. Under 13(3), the Fed could conceivably lend to a nonbank we deemed solvent, but only if it was in such deep trouble that no one else would lend to it, and even then only if we could secure collateral that could plausibly cover our exposure. So we wouldn’t be able to take much risk, and we wouldn’t have much preemptive power to help firms before they were past the point of no return, even if we thought the financial system depended on it. That struck me as a problem, too.

  Over the next few years, while financial markets and home prices and nationwide borrowing soared, my colleagues and I spent much of our time and energy trying to make the system more resilient, better prepared to withstand a crisis. Ultimately, of course, our efforts were insufficient. We failed to prevent the worst financial crisis and the deepest recession in generations. I had the dubious distinction of being in charge of the New York Fed when Wall Street imploded.

  The crisis later inspired a lot of commentary suggesting that the Fed was a reluctant regulator—and that I was too close to Wall Street, too confident in the competence and integrity of bankers, too devoted to the free-market fundamentalism I supposedly inherited from Rubin, Summers, and Greenspan. I was routinely described as a tool of the industry, bent by the banks. Even critics who didn’t suggest I was corrupt assumed I was captured by the establishment’s finance-friendly view of the world. So before I explain what we did at the New York Fed and why, as well as what we missed and why, I want to describe my attitudes toward the financial world when I started the job.

  I HAD never thought
of finance as a particularly special or prestigious profession.

  My classmates who headed to Wall Street weren’t disproportionately smart or distinguished, though they weren’t especially dim or ethically challenged, either. Reading Liar’s Poker, Michael Lewis’s scathing portrait of life in the bond markets, reinforced my view of finance as a business I wouldn’t be good at and couldn’t imagine being part of. I remember after the death of Carole’s mother in 1987, a trauma that inspired her to write a young-adult novel about life after losing a parent, her Merrill Lynch broker called to urge us to shift her modest inheritance into some new securities. He was obviously motivated by what his firm wanted to sell, not by what made sense for us, leaving me with a distaste that I never forgot.

  At Treasury in the 1990s, I witnessed repeated episodes of finance at its worst. In Japan, I saw a banking system that had gotten wrapped up with crime syndicates known as yakuzas while financing a real estate boom. And the relationships between the bureaucrats of the Japanese finance ministry and the institutions they were supposed to supervise were so close it was hard to tell who was running whom. I then watched more financial booms blow up in Latin America, Asia, and Russia. I learned how vulnerable markets could be to herd behavior, to uninformed, indiscriminate shifts in sentiments. Many financiers who lent money in Asia did not seem to know much about the risks they were taking or the countries they were playing in.

  But I did not view Wall Street as a cabal of idiots or crooks. My jobs mostly exposed me to talented senior bankers, and selection bias probably gave me an impression that the U.S. financial sector was more capable and ethical than it really was. I spent more time with smart executives such as Deryck Maughan, a Salomon Brothers banker I knew in Japan who later became CEO, and smart investors such as Stan Druckenmiller, a hedge fund billionaire I sometimes consulted about markets, than I spent with the sordid elements of the financial industry. And working for Secretary Rubin surely affected my view of Wall Street competence, because he was as competent as anyone I knew.