breaking the bank

Simon Johnson


A professor at MIT's Sloan School of Management, senior fellow at the Peterson Institute for International Economics and former chief economist at the International Monetary Fund, Johnson co-authors the blog The Baseline Scenario. This is the edited transcript of an interview conducted on Feb. 24, 2009.

Sept. 15, 2008: Bear Stearns has happened; Lehman has gone under; Merrill Lynch [is bought] by America's biggest bank, BofA [Bank of America]. What are you thinking?

On that Monday, I thought it was business as usual. I think that Monday is what [House Financial Services Committee Chair Rep.] Barney Frank [D-Mass.] called "Bailout Free Day"; it just seemed like this was what the federal government usually does -- arranges some sort of change of relationships within the private sector. So Bank of America had been expanding, they'd done their Countrywide deal, and now they could add Merrill. They've become a massive behemoth, and that just seemed kind of normal.

It was then Tuesday and Wednesday when I started to feel this really wasn't business as usual at all, and it was going to go very badly for lots of people.

What did you see happening on Tuesday, Wednesday that convinced you things were going badly?

A friend of mine called me up on the Wednesday. I was teaching, was somewhat distracted. He and I worked for 20 years in various emerging market crises -- big meltdowns in Russia, Argentina, Indonesia. He called me up and said, "Simon, the financial markets just died around the world."

“We'll wake up one day, there'll be a story in the paper: ... 'The Fed now provides 70, 80, 90 percent of the credit in the U.S. economy.'”

I take this guy very seriously -- we've worked together in a lot of these situations. I said, "How could this be?" He said, "Well, it was the failure of Lehman," after the Fed had reassured people up to the last minute that Lehman wasn't going to fail. And then it was the way in which they were rescuing AIG [American International Group], which happened late on the Tuesday -- and we really saw the implications of that on the Wednesday.

So AIG was rescued, but the senior secured creditors in AIG took about a 40 percent hit. An AAA credit had suddenly become junk, or worse than junk, and that was clearly a huge shock to everyone's confidence, including my friend's. And my friend made the right call.

So you see the credit markets freeze, the paper market is locked up, car loans -- nothing's moving. What does that mean?

I don't think we saw or understood that level of granularity right away.

What I felt was the global part of it. My background is working around the world. I know a lot of people who are engaged in financial markets, and I called a number of them that Wednesday, and a few more on the Thursday morning. And they all told me the same thing.

So to me, the striking thing was the synchronicity and global nature of the shock. Afterward, I realized it was in every single market segment in the United States. But the fact that the whole world had lost confidence in credit at the same moment? That was really shocking.

Why had that happened?

I don't think we completely understand that, even now. Obviously, looking back, there was a web of relationships, and these multinational banks had interconnected themselves. They'd also pulled in lots of other parts of the world directly or indirectly. ... So a consumer in India or a farmer in China is much more connected to Lehman Brothers, to AIG, to New York and Washington than we previously realized.

And the financial market kind of figured that out, I think, on the Wednesday and was screaming at us that this was a massive global financial meltdown.

Let's go back to March 10, 2008, when Bear Stearns starts to melt down. … What did it mean for one of the five investment banks in the country to be in that kind of state?

It was an early warning that this wasn't business as usual. So prior to that, we'd seen pressures, we'd seen a need for capital from the big investment banks, and we'd seen them more or less be able to raise capital. Increasingly, it was on less and less favorable terms for themselves.

But that Bear Stearns collapse was really a stomach-churning moment. I remember a friend and colleague at the IMF saying to me on the Thursday evening after I said to him: "I think that Bear Stearns is going to fail; it's going to go out of business. But I think it will do it on the weekend; we can get to the weekend. We just need to get to the weekend." This was Thursday night, he says to me, "Simon, there's a lot of trading hours between now, Thursday evening and the weekend." And he was right.

If you remember, Friday morning there was an attempted rescue by the Fed. It failed Friday morning, and they had to do another package Friday afternoon. Of course, they did the real rescue and the sale involving JPMorgan over the weekend. So it was the speed at which this moves.

Financial market time, I think, is Internet time but with teeth: Things get out of control, and it really hurts you and hurts the world economy.

When Bear Stearns begins to go down, what's the significance of that moment? … It's the first sign of the government stepping in. [Did they make a mistake?]

My take on that is it was [then-Treasury Secretary Henry] Paulson and [then-New York Federal Reserve President Tim] Geithner -- it was the deal-making kind of philosophy that really saved Bear Stearns.

To me, the mistake was actually not saving it. To me, the mistake was that on every Monday and Wednesday after that, for about four months, people were saying, "OK, take this opportunity to do something more systematic for the rest of the banking system before it gets out of control again."

And the attitude, I think particularly of Secretary Paulson, was: "What do you mean? We did this great deal over a weekend; we moved things around. There's no need for a systemic solution. If the system ever does come under threat, we'll be able to deal with it either in the same case-by-case way, or in some more systematic way which we'll figure out at the time."

So to my mind, they took that calm after Bear Stearns as an indication that they could be complacent. And that complacency is exactly what led us into another spiral -- the events we couldn't control in September.

Tell me the story about your being at the IMF -- it's August 2007 -- and you are all noticing things: fractures, tremors, etc.

The IMF is charged with looking around the world economy and figuring out where the problems are, because the main job usually is emerging markets.

In late July-early August 2007 it became clear something had gone badly wrong, not just in subprime mortgages but in the securitized markets built on those mortgages. And there were some amazing moments. I remember looking at these and discussing with my colleagues. When BNP Paribas suspended payments because they said it was hard to value what was in their funds, my reaction to that was, there's a lot of things that are hard to value, but that's because they're worth nothing, so that sounds like a smoke screen.

And as soon as we started to engage in this issue, we immediately encountered a lot of pushback and friction with officials. So the IMF engages with officials from G7 industrial countries, and we tried to talk to them a lot behind the scenes delicately. And I can't tell you the full nature of those conversations, but it's a matter of public record what they said to us and what they said more generally, not just in August but also September, October and more or less for almost a year after that. This is 2007 I'm talking about.

They were saying, "It's not really that bad; it's going to be contained." There was a lot of, I think, denial and refusal to deal with the issues.

And this was definitely the case of the U.S. government, both Treasury and, I'm afraid to say, Federal Reserve. It was even worse, in my opinion, in Europe. The French and the Germans, in particular, but also the British were completely disinclined to believe this was a system problem. Even after a couple of German banks went down, they said, "Well, those were small German banks." Even after Northern Rock, a big U.K. mortgage lender, went down, "Well, that was just Northern Rock and really doesn't tell us anything more general about the system."

And every time we'd be trying to revise down our view of the world economy, we would get pushback from those officials who would say we were exaggerating, we were being too pessimistic, we were making the problem worse by trying to be more honest about it.

And for a while we went along with that; we had to go along with that. But Bear Stearns, for me, really was the end of the charades.

Why were governments wary of acknowledging at least the possibility of systemic problems?

That's really the fascinating question. I think the answer is in the culture of these organizations. These officials are brought up to think incrementally. In the postwar period, we didn't have big discontinuities for the most part in industrialized countries. Mostly you have relatively small changes, and policy-makers are trained not to overreact.

And so one part of not overreacting is not becoming too pessimistic, not saying the system could fail -- in fact, not even hinting. I remember one official deputy minister-level person said to me quite seriously: "If we even hint this would happen, the minister," who of course is a politician, "could become worried, and that would spread. He could communicate that more broadly on television or in some other way."

That's amazing. Even among yourselves you have to be tightly controlled, always cautiously optimistic, always having a bit of a recovery coming just around the corner and never wanting to move policy in a dramatic way. Always wanting to go step by step, deal by deal. Well, that's a mentality and organizational culture that prevents you from preparing, actually, for calamity.

... How much is moral hazard driving what Paulson's doing?

I think moral hazard was a big part of Secretary Paulson's religion about markets. And also it was partly a sort of affection for a dog-eat-dog world where you figure the relatively strong people on Wall Street will eat up the relatively weak people, and you get a bigger and more powerful Goldman Sachs or something else, Bank of America, coming out of it.

I think, though, the signals prior to the collapse of Lehman were mixed. I know the Federal Reserve was perceived as encouraging people not to cut their lines of credit to Lehman. So there may have been some discussions at the CEO level along [the lines of] "There will be no bailout, so find a partner; sell yourself." But at the market level, there was definitely a message that Lehman would not completely collapse.

I think it's the breakdown of trust and belief in the Federal Reserve and what it says to the markets about the solvency or the solidness of particular institutions that is a very important part of what happens after the collapse of Lehman and after what happens with AIG.

Did they know, do you figure, the extent to which pulling the pin on Lehman was going to have the effect it had?

No, they can't have. You wouldn't do that to yourself, to the world economy. And the fact they had this by now famous, flimsy document that they sent to Congress, three pages or so, it tells you how little they were prepared.

Back in the spring, after the collapse of Bear Stearns, there were other people who were working on what should you do; what's the systemic solution? And the IMF had one. It was a much more substantial document than three pages. It had been thought through; it had legal experts on it; it had banking experts work its way through. People had thought about the global implications. What does it do to your G7 partners, for example?

So the three pages tells me that no one was prepared. A contingency plan does not consist of three pages faxed to Congress for their consideration on a Thursday or a Friday.

How can it happen that something so fundamental can occur, and apparently no one at the Federal Reserve, no one at the Treasury Department has either seen or absorbed the IMF document?

When you run the biggest economy in the world and you've been very successful for 50 years, you become a little bit arrogant. I guess "hubris" is perhaps the appropriate word. Without question, you have one of the best runs of global economic dominance that anyone has ever had, right? So why should you take advice from other people?

The masters of the universe are not actually Wall Street people. They're the Treasury people and the Fed people who work closely with the Wall Street people and who have some sort of contiguous interests, let's say.

Those people don't take advice from people who are not part of that inner league.

So when they're sitting in [Speaker of the House] Nancy Pelosi's [D-Calif.] office that Thursday evening -- four days after Lehman goes down, three days after Bank of America and Merrill have merged together, AIG has just been bailed out for $85 billion -- and they say, "If you don't authorize our three pages in just a few days, the economy will completely stop functioning," everyone in the room is stunned and surprised and shocked. What does that tell you, that Congress were shocked by it?

I think this is where the breakdown of trust between the executive branch and the legislative branch occurred, and of course that spread broadly around the country and around the world.

The problem is that [Federal Reserve Chairman] Mr. Bernanke and Mr. Paulson had been saying all the prior week that the fundamentals are fine. And they were showing a path of the real economy which was perhaps a little bit of a recession -- I think back then we were still skirting recession -- and then we'd have a nice, smooth recovery.

I think the way I explain that conversation, that weekend in Speaker Pelosi's office in particular, is that Mr. Paulson, after saying everything was fine, he then came back a week later and said really, he needed 5 percent of GDP [gross domestic product] in small, unmarked bills placed in a brown paper bag outside his office. Otherwise, the world financial system would end.

It's that kind of shocking -- this guy's the secretary of the Treasury; he has all this infrastructure; these people know what they're doing. The institutions have known what they've been doing for 50 years, and suddenly they need what seemed back then to be a large amount of money. Of course, now it seems a relatively small amount of money. It was $700 billion at an unprecedented speed and unprecedented format.

That was deeply shocking. And by the way, also [shocking was] the way it was communicated, as I understand. I testified to the Senate Budget Committee back in January, and the senators went pointedly on the record, across the political spectrum, to emphasize how annoyed they were with Mr. Paulson and the way he communicated his message.

So I think there was a substance issue: How did this guy suddenly get this wrong? And there was an arrogance issue, too.

So Congress rejects the bill the first go-around, then it's kind of adapted. The original idea is we're going to buy up the toxic assets. There's a kind of thing slid in there that says we're going to be able to inject TARP [Troubled Asset Relief Program] money. So what happens to the idea of buying up the assets?

Basically Paulson got what he wanted, which was to be able to buy up the assets in some relatively complicated auction system to be named later. And I thought it was a crazy idea at the time: completely nontransparent, really primed to overpay for these assets.

But I and others sort of said, "Well, I suppose you have to do it."

We did recognize the global financial meltdown, after all, and you sort of have to support the Treasury and the Fed. I was arguing for just more oversight over this process.

But then the financial-sector problem spread really quickly to Europe. Iceland defaulted. It spread to other parts of the European banking system. There was a really crazy week in which the Germans in particular went from saying, "There is no problem at all," to saying, "We need to recapitalize our banking system." And they had an incredible weekend that started with a G7 meeting in Washington, ended with a euro zone meeting in Paris, a euro zone meeting to which the British were invited because they were in so much trouble also.

The Europeans recapitalized their banks on a Sunday. And Mr. Paulson and Mr. Bernanke decided they needed to follow suit, and they decided to use this TARP money -- this bailout money recapitalization mode -- for the U.S. banking system.

They didn't immediately shelve the idea of buying the toxic assets; that came a little bit later. But it was pretty clear they only had a limited amount of money and that they were going to put that bet on a fairly small-scale recapitalization of the U.S. banking system instead of buying assets.

You're talking about the Oct. 14 meeting when Paulson picks up the phone on the Sunday and says to the nine big banks, "I'm your new partner." Was it sort of the crossing of the Rubicon for both Paulson personally and the federal government, getting in the business of the banks?

I think we nationalized the banks in the U.S. on that day. Seriously -- substantially nationalized them. The government got a lot of say in how they're run, a lot of constraints, a lot of responsibilities. A lot of downside risk was taken on that day. It wasn't full nationalization. We didn't get upside participation; we didn't get to change the board of directors. We got the worst kind of nationalization, and I really don't know how much thought went into that. I suspect rather little.

It's amazing that Hank Paulson could go from Mr. Moral Hazard, Mr. Goldman Sachs, a private-sector kind of model to being the guy, I think, who nationalized and socialized in a very bad, unproductive way that's hard to extricate ourselves from the U.S. banking system.

Was it wildly impossible and impractical that the Treasury Department of the United States government would be able to get into the banks, look at all their books, buy up all the bad stuff?

The real issue was a very simple one: If the Treasury was willing to pay more than the market value of these assets, of course people would sell them, right? But that's a hidden subsidy, probably. If you offer market prices for this stuff, oh, maybe I'll just sit on my junk. ...

So the key question was, was Treasury going to be able to construct both an economic mechanism, and also a politically legitimate way of overpaying for the assets? I think they tried to think about how to set up some sort of auction in which this would happen. But I think the political legitimacy part was very quickly a problem for them.

... Do the banks know what they're getting into?

A little bit. To give them some credit, the banks are wary of the government, and I think they must have sensed -- I don't know if they could have articulated this then or anytime soon afterward -- that this would come with a lot more scrutiny.

Banking is a business best done with the curtains drawn and not too many people looking over you. There's a lot of funny stuff on the books of these banks, as we have now found out, right? And the fact that the government has this stake and a say and feels that they'd like to know what happened to the money, I don't think it really transforms the banking system. I think the banks are still up to a lot of their old tricks, but there's no question that it does press them to be more transparent about more things than in the past.

And from Paulson's perspective, why didn't they put more conditions on it? "We're going to give you this money. Go out and lend now. Get people to spend. Get some confidence going." Why weren't those requirements part of the deal?

A very good question. I don't know, but I think it was two reasons. First, they thought that would happen automatically, that this would be sort of naturally the money would get lent out, it would restore confidence. The U.S. government, after all, is standing behind the balance sheet of these banks.

And secondly, of course, Mr. Paulson is a hands-off guy. He doesn't want the government to micromanage, and he's drawing a line in the sand somehow there.

I think he completely misconstrued it. I think the line was somewhere else, and he did the nationalization. But he decides that this will somehow keep the government out of the business of the banks, and that's a better way to do it.

Is it accidental nationalization?

It was deliberate nationalization. I think that it was a little bit unplanned, spontaneous nationalization almost, you might call it. It was an unprofessional nationalization; that's what it was.

If you look at how the Swedes took over their banking system, if you go through the documents, talk to the people who were involved in that, they had a big problem; it started in housing. This is in the 1990s. They thought about it, brought in a lot of professionals. They tried to depoliticize it by making it very professional and making sort of state-of-the-art best practice.

You've got to drop moral hazard. You've got to drop the whole religious kind of angle. You just do what makes sense in the situation, or, if I can suggest, do what the IMF would propose in a country which isn't terribly politicized and where they can come in and sort of tell you technically what makes sense. That's what the Swedes did. We Americans didn't. We did something very amateurish, actually.

... What's the government doing during that period of time, October to November 2008?

The federal government is holding the entire credit system up. So this is part of the nationalization that we did in this kind of backdoor way. The Federal Reserve is providing mass amounts of credit, both to these banks -- and some of these lines of credit, that's very important for their continued operation -- and also to the securities market. The Fed is increasingly buying commercial paper. It expands its scope to buy other kinds of securitized loans.

So basically the Federal Reserve, the central bank, also becomes a commercial bank, takes over lending to the economy. As the banks go down, the banks struggle; the banks can't lend, don't want to lend, whatever the reason. The Fed steps in, and then you have a rise of something we last saw right before the Soviet Union collapsed. Right before Gorbachev's reforms, they had one bank called Gosbank, or State Bank, which was the central bank and the commercial bank for the entire system. Between October and November, that's what the Fed really started to become.

And the implications of that are?

We don't know yet. The implications are we've changed the nature of our economy quite fundamentally. And the Federal Reserve is responsible for whether or not your kids can get a loan to go to college. That's very strange and somewhat uncomfortable, because if your kids can't get a loan, you could call up your congressperson and have your congressperson call the Fed and say: "There's a college; there's a kid. We know college education is good; you get a good return on it; we need a loan," and none of this arguing back and forth. "You work for me now; you're on the government payroll, more or less." And certainly the Fed is. They have some semblance of independence, but Congress can call the shots when they need to. "Let's get that loan out." So you politicized the credit system.

And what's wrong with that?

(Laughs.) Well, what's wrong with that is it gets out of control. Everywhere in the world where you have a very politicized credit system, there's too much lending to people who aren't creditworthy.

Remember, we got into this problem that we're in because private banks created an incentive system that made inappropriate loans to people who shouldn't have taken the loans. So the people who did take the loans made a mistake and perhaps are somewhat to blame. But the very powerful, well-heeled banks knew exactly what they were doing and actually knew these people were going to default.

What you could replace that with, if you're not careful, is a politicized credit system in which people who aren't creditworthy are lulled into thinking they should take out loans not by private banks but by the government or by the Federal Reserve's credit system. We could have a credit problem going forward that would make the subprime look trivial.

[CEO] Ken Lewis and Bank of America -- he makes a bet on Countrywide and on Merrill Lynch that everything is going to be OK; this toxic stuff somehow is going to get dealt with. But they didn't buy off the toxic assets. So to what extent is the government hurting Ken Lewis' bet on Merrill and the way he runs his bank?

Ken's bet was on the macroeconomy, on the housing market more broadly. He was very happy to buy Countrywide, and they did an enormous amount of due diligence to understand exactly what they were buying. And they were buying a way to make loans to certain kinds of people. They were getting away from that bricks and mortar -- Bank of America's traditional retail branch strategy. And they were buying something very diversified: ... access to housing lending all around the country, and it wasn't just subprime; it was a variety. Maybe you could do subprime this year; you might switch to conforming mortgages, so higher quality mortgages the next year. You could use this in various ways.

The mistake was believing that the whole housing market couldn't go down, the whole macroeconomy couldn't decline. So basically, it was the biggest of all the big bets on housing.

It was the financial crisis of mid-September that really caused the damage to Bank of America. Merrill, in some sense, is the very bad-tasting icing on the cake, because they bought Merrill without due diligence, without really understanding it. And on top of this big housing bet, they added a whole other level of complex stuff that was also a housing bet.

So he just basically bit off more than he could chew in a time when he shouldn't be chewing at all?

It's all about framing. He had a good choice to buy Lehman or buy Merrill or do other things on that key weekend in September. And I think when you present a choice to people, you say, "Look, you can have this, which is not very good, or you can have this, which is much better." They'll say, "Well, of course I'll have Merrill; that's much better."

But I didn't say it was good, right? I didn't say that it would really help your business; I just said it was better. But somehow when that choice is framed in those terms, you tend to go toward the "better" option.

And when it's being framed by the federal government, by Paulson, Geithner and Bernanke, as it was that weekend to Lewis, which was, "We really need you to take Lehman, but if you're not going to take Lehman, we absolutely need you to take Merrill, because boy, we can't take the one-two hit of Lehman-Merrill, and Merrill's next."

Yes, and after Merrill, the next would have been Goldman. So that was the sequence of dominoes.

But he could say no. I don't think anybody can really force you to buy a complete lemon like that. I think it was tempting. I think it played to perhaps his ego, certainly, what he was trying to do with the bank. There's a cachet to the name of Merrill, and that feels good.

And remember, the way it usually happens in the United States is you hit some sort of bump in the road, some banks fail, other banks snap them up, and from that you build your brilliant, great empire. The idea that this thing ... that you snap up can actually destroy or damage the acquirer -- we're getting used to that idea, but it's pretty new.

By the middle of December, he'd like out of the deal. … Lewis flies up, sits down with Paulson and Bernanke, and basically they say, "You can't walk away from this." What is the implication of that, given what happened in October and given what happened in September?

I think they probably thought they were just negotiating. These are Wall Street people, dealmakers, and the question was the price: How much would Bank of America have to be paid or be helped out by the government in this context? So I think there was some very high-level haggling. …

The government's in a bit of a barrel -- you can't walk away yourself very easily. The loss of prestige to say, "We goofed," would be pretty bad. But maybe you can get some more money out of the government.

Remember, this is before the scrutiny that comes with government money was really at the front of everyone's minds. So looking back you say, "How could they be so crazy?" And obviously we were going to come after their bonuses and want to know a lot more and push more about how they run their banks. But back at that moment, it was still kind of a closed-door, clubby bailout arrangement.

[What happened in Washington between mid-December and mid-January?]

There was obviously an interregnum. There was this gap. ... The old president was done, and his authority was diminished, and the new president wasn't willing, and I guess his constitutional advisers told him not to be willing to really step up and take the lead there.

I think the issue, to my mind, in terms of the strategy of the incoming team was they had an opportunity to craft it and articulate it in November, and that would have shaped the debate, and it would have shaped what you thought you could do with the banks.

And for some reason, they chose to focus just on the fiscal strategy and put that forward, and every discussion became around the fiscal stimulus. The banks were left by themselves to decide.

Of course, Bank of America did get an additional bailout in mid-January, and Citigroup got one right before Thanksgiving. So I don't know who was deciding the terms of those deals, which were different from what we had before and really quite important for what happens next.

What happens next?

The public finds out things are not being done very well, and the economy looks bad, and just electing a new president doesn't mean there's a miraculous cure, and they start wondering about the money that was spent on the banks. And of course you have to come back for the second part of this TARP money, second $350 billion. Mr. Paulson has pre-spent a little bit of that, but there's a conversation that has to come through Congress in January.

And so at that point, the people start to drill down into this. And of course [Merrill Lynch CEO] John Thain's redecorating of his office becomes news right at this moment.

... What does it mean to bring [the financial sector] under control?

... There are some technical things. There's issues of recapitalizing the banking system, cleaning it up. ... It's not that difficult, but the politics are almost impossible, because what you're talking about is a massive change in the power structure. These banks dominate a big chunk of the American economy, and they're incredibly well-represented in Congress and in the administration. There's a culture, there's a web of interest, if you like, between these people. That is how we run the economy. It worked for 50 years. How are you going to change that? ...

I'm an optimistic, positive guy. ... It's never over. The economy's not going to end; the country's not going to break apart; we will get out of this. But we could lose a decade, and I don't see the point in not being honest with people about that.

In fact, why should you take any kind of radical, big proposal seriously unless you think there's a high probability of very bad outcomes? I think there's a dissonance there that doesn't make sense to people when you talk to them like this. ... When you hear a big speech, you might buy it for a while, but eventually you're going to say: "Well, I don't understand. Why are we doing these big things if the problem isn't that bad?"...

… There are lurching efforts at different solutions. Take me through the precursors to the final acceptance of the idea that maybe "nationalization" isn't such a bad word.

The basic problem is this: When your banking system fails, when it makes a massive amount of bad loans and you realize those loans have all gone bad, it needs a lot more capital, OK? This is totally standard. I mean, this is [an] absolutely generic banking-sector crisis. Almost every country's had one; many countries have them with some regularity. There's a textbook way to approach this.

Now, the U.S. hasn't had this kind of crisis, and the U.S. is very uncomfortable with putting in new capital to the banking system because the capital would come from the government. Only the government would be willing to come in at this moment. And if you put in a lot of capital, you should surely get something in return, like shares. And then you're going to own a lot of the banking system.

That logic is well-known throughout the government circles. The question is, is there a way to finesse that? Is there a way to, for example, take away the toxic assets or take pay above market prices?

This is back to the original Paulson idea, right? The original Paulson idea was a nationalization-avoidance mechanism. And in December and January they went through some of the same dance and I think to some degree are still interested in these ideas of avoiding the government putting in large amounts of capital and avoiding -- you can call it a nationalization; I like to call it "a step toward reprivatization."

I think we already nationalized the banks back in October. We already got the worst sides of nationalization: control, downside risk and so on. I think the government comes in, becomes a majority owner and then can immediately sell off the bank, sell a controlling stake to new private-sector owners. And those private-sector owners would change the board of directors; a new board would sort out the management of these companies.

So get the banks away from the state and into the private sector is my line. But most people see this as government takeover -- you know, the U.S. bank system becomes more like the post office, which most people think is not a good idea.

But that's a serious consideration. And people are actually talking about this?

The problem is, how do you avoid it? If you continue to have these kinds of losses, if the private sector doesn't want to put in capital, there's a limit to the sort of contortions the government can go through.

One contortion is the so-called preferred equity. So we put in capital back in October. It's preferred stock, not as common stock, the difference being preferred stock doesn't get to vote. It gets a dividend, so it's a little bit more like debt, but it doesn't change the ownership structure of the company. It doesn't give you a right to say who should be on the board of directors.

But there's a limit to how much of that you can put in relative to the size of the company, relative to the value of the common stock, before it just becomes far too awkward. And we're fast approaching that limit.

So what is Ken Lewis' path out?

It's very hard to say what he knows and doesn't know. The second bailout that he got in mid-January, this government insurance scheme, was an incredible subsidy, arguably a bigger giveaway than what they all got in October. So, presumably, he needed that bailout in order to save the bank. It's hard to imagine why he would have signed up for it otherwise.

And I think saying that he would rather run the bank without the government involvement is posturing, because we deserve some return on our investment in his bank, and we didn't get it with the terms of the last gasp. The terms for Bank of America at the end of the Paulson regime were incredibly generous. So now he throws it back in our face and says he'd do better without the taxpayer? Well, I'm almost inclined to take him up on the offer, but I rather fear the consequences.

… What are the strengths and weaknesses of superbanks?

The superbanks were sort of exercises in empire building and aggrandizement of the CEOs, who get to be very important people. The evidence that these are much more efficient ways of intermediating capital, their basic job -- take it from savers, let it find its way to people who want to borrow -- that evidence is very limited. Clearly, though, they've become very powerful politically. Citigroup has some cachet in Washington. So does Bank of America now, and that's very valuable.

There are people who say the main job of the CEO is actually lobbyist, because the CEOs can't control these banks anymore. For example, nobody understands the risks that they've taken on in these kind of global businesses and their very complicated derivative businesses. I think it's self-evident that nobody understood those businesses because they couldn't have messed up in this way if they had.

So the superbanks I think are finished, should be finished. They're not very efficient, they're politically way too powerful, and they should be broken up and go into decline. Whether they will or not depends on the success of their CEOs in terms of their political lobbying. So that, I think, is where the struggle is right now.

The Obama administration in its early going, what are its challenges, and what so far have been its responses?

The Obama administration obviously decided to stress the fiscal stimulus, and they put a lot of effort into that, and the banking sort of played second fiddle. It was always, "We'll tell you a little bit later what our banking strategy is," and that was really epitomized by President Obama's very good press conference where he covered a lot of topics. He warned us of a lost decade, but in a reassuring way, which is quite an amazing feat to pull it off.

And then he said, "Secretary Geithner will tell you the details tomorrow of how we'll save the banking system." So we were all on the edge of our chairs. I was sitting in front of Bloomberg News Channel, and the start of Secretary Geithner's speech was very good. It was an admission of the problems. He stated that government had made mistakes, and that included him, because he'd been on the previous team. And he gave some pretty reasonable detail. He said, "Nobody trusts the government anymore." And I thought, well, this is actually quite promising.

And then he said, "And we put in place executive compensation caps that are meaningful." Now, the caps they had proposed at that time were a joke, and they've been revised or [are] in the process of being revised because it's widely acknowledged to be a fairly bad joke. And as soon as he said that, I thought, oh, I think this is not going to go so well.

And then he went on to lay out some strange mixture of what Paulson had already tried and failed, what Paulson wouldn't have even tried because it clearly was going to fail, and some other things like on housing, which seems OK, but nothing decisive, nothing compelling, nothing that really breaks through the situation.

And it's a big problem that still hangs over all our heads. It is a massive lead weight holding by a string. The string is fraying. What are we going to do, pretend it's not there? Go buy some new strings so after it drops on our head, we can hang it up again? These are not good options.

Is it that they can't get their hands around it? Or is it, as you say, this thing that's been ongoing -- we can't convey fear to the people?

I think President Obama can easily handle telling you how bad things are and convincing you that there's a sensible plan and a strategy. I think it's political at a different level.

These banks and the people who support them don't want too much change. It's a system that's worked pretty well for 40 or 50 years. Maybe the economy will get better. No one could quite explain to you why, but a miracle could occur, and maybe you would regret dismantling this banking structure that had served you well, supposedly, for quite a long period of time.

So let's just wait and see. And that's the philosophy right now. See if the economy recovers. The banks can stay as they are. The bad loan problems will go away. If the economy doesn't recover, we'll deal with it then.

Of course, the problem with that approach is "deal with it then" was what Mr. Paulson said after Bear Stearns failed. "We don't need a plan; we don't need to sort out the system. If it gets worse, we'll deal with it then." Well, that led to Lehman and the AIG fiasco and the financial meltdown.

You talked about the administration sort of setting the banks aside and dealing with the stimulus. What are the implications of setting the banks aside?

The problem is obviously getting worse and becoming clearer to people. The basic problem is the real economy is getting worse. People are losing their jobs, can't make payments on their houses, walking away from their mortgages. Those houses are being sold; that pushes down house prices further and leads to more foreclosures.

At the same time, other parts of the recession are impacting commercial real estate; credit card loans are going bad; student loans are, as far as we know, also going bad. It's spreading, and it's all on the bank's balance sheets. They have it in securitized forms that, just like with subprime, you had a bit of a problem; it gets amplified because of the way they structured these securities. It's the same thing happening across the economy, across all these different kinds of debt.

So the theory is that as that happens in kind of piecemeal fashion, the Fed will give a little money to the banks and keep them alive; take a little bigger stake in every bank; maybe go from preferred to common stock; and slowly, incrementally, lend more and more and more to prop up the banks -- until what?

Until it just becomes too awkward; until you're providing them with all the capital that they have left and all the credit they can draw, and then you say, "This is the government running the credit system," without really getting to choose who runs the banks or making decisions about the size of the banks.

And of course there's going to be a lot of pressure to politicize this kind of lending. So congressmen and senators calling up, asking for this or that project to be approved, that's also going to be extremely awkward.

Much better to privatize the whole thing. You know, government comes in and then gets out like the FDIC [Federal Deposit Insurance Corp.] does usually -- big, FDIC-takeover kind of model, because then you get out. You put it back to the private sector, sell it to new owners, let those owners come in. That's the key.

That's the theory. It's one thing when it's a small bank in Nebraska over a weekend; it's another thing when it's Bank of America, yes?

Yes. We haven't done it before, that's true. There's no reason why you can't do it. These banks can be managed differently, just like other banks FDIC takes over. Remember, when you take over a bank, you don't shut it down. It's rather like Chapter 11 bankruptcy for airlines. You continue to operate with some financing put in place or prearranged, and the understanding being that you're going to try to come out of Chapter 11 after you've restructured some of the contracts that you have, and obviously after your shareholders have taken a loss.

Will we know when the nationalization or whatever it's called actually occurs? Will there be a big sign that goes up, or is it happening anyway, and it's so incremental that we kind of don't know?

I think it's happening anyway. It has happened.

I think we'll wake up one day and there will be a story in the paper that says, "Oh, by the way, the Fed now provides essentially, one way or another, 70, 80, 90 percent of the credit in the U.S. economy." And we're going to be, "Oh, how did that happen?"

That's nationalization of the credit system. Even though you haven't nationalized ownership of the banks, the Fed becoming more important as a driver and the provider of commercial credit is the same thing. So you'll know if the government takes over Bank of America; there will be a big sign up. But I think you'll wake up, [and] it will dawn on you that the government is running the credit system. I think it will happen sooner rather than later.

... The idea that the Federal Reserve has become a commercial bank, what's the story there? ...

The Federal Reserve becoming a commercial bank is, like all really big transformations, something that happens, or happened, incrementally. ...

I remember after the Bear Stearns deal, they announced a facility -- I honestly don't remember the acronym anymore because we've been through so many permutations -- they announced a facility that I believe was a 90-day term. ... And of course, here we are a year later, and [there's been] some mixture [that] extended it and expanded it and changed the acronyms. Forget the acronyms -- the Fed is providing a massive amount of credit directly to the economy.

Now, I'm not saying they should withdraw that; I'm not saying it's a bad thing. But I'm saying it's a new thing, and I'm saying the Fed is your banker, increasingly, for many American households and companies. And sooner or later it will have to disengage from that, and that's going to be difficult.


Because if the Fed really is the banker to everyone and for everything, then the chairman of the House Financial Services Committee is the owner or controller or overseer of your banker. And he or she, whoever it is at that time, even the best possible person -- I have a great deal of admiration for [House Financial Service Committee Chair Rep.] Barney Frank [D-Mass.], for example, who's in that position; has done a great job I think, so far -- it's just too tempting for politicians to be involved in banking.

When politics and banking get mixed up, when the politicians decide who gets a loan, it always goes badly everywhere in the world. Why should the U.S. be any different? ...

The two relevant characters in this, Bernanke and Geithner -- I mean, that really means Bernanke is the man in terms of the American economy, to the extent that he gets to decide where the Fed puts its money and how much of the economy it saves and represents, yes?

Bernanke is very important, obviously, but if we're in the territory of bailouts and making deals, that's more the job of the Treasury secretary. So that was Paulson. Paulson was the lead in September, October for that reason. To the extent it drifts over into the Fed providing massive lines of credit -- and Secretary Geithner announced there will be an extension of that approach -- that makes Bernanke more central.

So I think we're in a little bit of a drift from Treasury to Bernanke. But if a big bank comes under pressure, a big bank has to be rescued, then it goes back to Treasury, because they do the deals.

Geithner: Have you ever met him? Do you know him in any way?

No, I don't. ... I obviously know of him, and our paths have crossed without actually meeting for many years.

Does he seem likely to be the right kind of person in terms of [curriculum] vitae and other things that make him appropriate for this crisis?

I don't know. It's hard to say. Nixon went to China, right? You wouldn't have picked Nixon as the guy to do that. Geithner seems like somebody who's very close to the finance industry. He has a lot of relationships both from his official role when he was in Washington at Treasury and from his job [as president and CEO] at the New York Fed. But he could be exactly the right guy to sort of break with this existing web of interests. He really understands how the system works, and perhaps under the present events, he will shift his view of the world.

There was word of struggle inside the Obama administration between [Senior Adviser David] Axelrod and Geithner about his speech and what he would say, and about what to do about this. Is it possible to know who won in that struggle, or who's winning in that struggle and what side anybody's on? …

My interpretation of that, which of course may be wrong, is that the political side of the White House, with both Axelrod and [Chief of Staff] Rahm Emanuel, wanted to be tougher on the banks. And Treasury's view, represented by Geithner, was, no, you should actually be relatively gentle on the banks in terms of compensation caps, for example, because we want the banks to bring themselves back to life. And the only way they can do that is if we're relatively gentle with them.

And it kind of makes sense. The politicians feel this sense of distrust and anger among the public vis-à-vis the banks, and they'd like to articulate that or see it reflected in policy. And Treasury is, obviously, traditionally close to Wall Street and sticks up for them in these kinds of discussions. And they're saying, "No, no if you push too hard, you'll just make the financial system problems worse." So I think that story as reported makes some sense. …

What are your worries about Geithner and that closeness to the banks?

Secretary Geithner obviously was the point person representing the American authorities in New York throughout this whole period of crisis. So as the [then]-president of the New York Fed, [he] has a very close relationship with the big banks, and he or she is supposed to be some combination of hand-holder, good cop to someone else's bad cop, and a little bit the representative who's on both sides -- an ambassador, perhaps.

Now, the problem with ambassadors is they sometimes get too close to the people in the country where they're representing you, and when they come back, you often want to shift them around to another job.

Now, Mr. Geithner has ascended to this position of pre-eminent power, and we don't know: Is he going to use that position to defend the banks and, I would say, the bankers? We're going to have banks; we want to have banks. In fact, we own the banks. It was our mutual funds that took a big nosedive when the share price went down.

The key question is, the people who run the banks, these executives, and also the boards of directors who are largely appointed by the executives -- the shareholders have been weak in these banks for a long time -- are we protecting these individuals who are powerful? I'm sure they're very likable; I'm sure there's a strong bond of friendship, and they've been through a lot together, and they did deals. They saved the day around Bear Stearns with this kind of deal.

Are we going to do more of that? Or is Secretary Geithner going to be tougher on them and push for new, stronger, outside owners, which could come through an FDIC intervention, takeover-type process, changes in the boards of directors? I don't think the secretary of the Treasury should go around firing CEOs -- that's going to be very messy -- but changing the governance of these banks, and also -- I think this is really critical -- putting in place a new, modernized antitrust structure so whoever is the new owner feels a great deal of pressure to break up these banks. Any bank that's too big to fail, in my opinion, is too big to exist. And that's pretty much the sole responsibility of the Treasury, of the secretary, to agree or disagree, to articulate that strategy, to take it to Congress. And I'm sure it would be a lot of work to make it happen. We don't know yet which way Secretary Geithner is going to go.

What's your perspective on how [National Economic Council Director] Larry Summers is in the mix?

Larry Summers, I think in this whole discussion around banks, is something of a wild card. We know more about Tim Geithner's positions and where he's coming from.

Larry Summers, of course, under the Clinton administration was quite famous for representing or advancing the view there should be deregulation of financial markets. He's also quite well-known now to have changed his mind on that. He's a very flexible guy. He's a very smart intellectual, former president of Harvard, as well as former secretary of the Treasury himself.

So which way is he going to go on this? Is he going to want to push more on the political side on, "Yes, we can be tough with bankers and still make this economic strategy work"? And remember, he also has responsibility for the broader coordination of economic policies, not just about the financial sector, which is more Mr. Geithner's responsibility. He's about everything: the fiscal stimulus, perhaps even the monetary side more, certainly the housing side.

So which way is Larry Summers going to go? I think he could swing the balance. I think on the one hand, you've got Geithner; on the other hand, you've got Axelrod and Emanuel. Summers can determine, if you like, the balance there. And I think what the president decides is the right thing to do -- the president is obviously very smart, makes up his own mind, hires good people, the best people available -- but they're almost certainly telling him different things.

So do you listen to the people who are more of the technocratic type or people who are more political? In that balance, Larry Summers is a technocrat, strong technocratic credentials, who's very politically savvy. Which way does he tell you to go on this critical issue? We don't know yet.

posted june 16, 2009

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