Vincent Reinhart on Bear Stearns, Lehman Brothers, and the Financial Crisis
Mar 28 2011

Vincent Reinhart of the American Enterprise Institute talks with EconTalk host Russ Roberts about the government interventions and non-interventions into financial markets in 2008. Conventional wisdom holds that the failure to intervene in the collapse of Lehman Brothers precipitated the crisis. Reinhart argues that the key event occurred months earlier when the government engineered a shotgun marriage of Bear Stearns to JP Morgan Chase by guaranteeing billion of Bear's assets and sending a signal to creditors that risky lending might come without a cost. Reinhart argues that there is a wider menu of choices available to policy makers than simply rescue or no rescue, and that it is important to take action before the crisis comes to a head.

Barry Ritholtz on Bailouts, the Fed, and the Crisis
Barry Ritholtz, author of Bailout Nation: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy, talks with EconTalk host Russ Roberts about the history of bailouts in recent times, beginning with Lockheed and Chrysler in the...
Arnold Kling on Freddie and Fannie and the Recent History of the U.S. Housing Market
Arnold Kling of EconLog talks with host Russ Roberts about the economics of the housing market with a focus on the role of Fannie Mae and Freddie Mac. The conversation closes with a postscript on the current financial crisis.
Explore audio transcript, further reading that will help you delve deeper into this week’s episode, and vigorous conversations in the form of our comments section below.


David B. Collum
Mar 28 2011 at 9:52am

I think you guys did a great job. As I listen to these podcasts, however, I find rehashing the crisis leaves me feeling physically anxious. With that said…

1. The key message, in my opinion, is that this mess was created “upstream”–I would argue way upstream–and that any justification of action during the crisis tends to distract attention away from the source. Vincent did indeed catch the essence of this in the summary.

2. You forgot to mention that Bagehot also suggested that such lending into the teeth of a liquidity crisis should be at punitive rates. They certainly blew this one.

3. We have solved none of the systemic problems. The big banks are still not marking to market. They are still insolvent despite enormous pumping of liquidity. What we do seem to have done, however, is put into place mechanisms for unlimited bank support (infinite moral hazard) in a way that would have been unimaginable a few years back. How many were shocked by the $30 billion backstop for Bear? I certainly was. How many find that number quaint now?

4. There is a lot of lying about the costs. They have simply distributed them. I personally am undercompensated by treasury-backed money markets at 0.000…%. I am losing relative to inflation (especially the real rather than fictional measures.)

5. There is only one guy in prison right now as a result of the mortgage crisis–a guy named Engle who lied on his no-doc mortgage application.

I had a discussion with the former head of fixed income at Bear Stearns (an argument actually): He claimed to see the problem coming and failed to alert the higher ups. Maybe, maybe not. He was not contrite enough for my tastes. He noted that you couldn’t put a guy in prison for being stupid. Let’s stretch our imaginations to their limits and blame it on just stupidity. I think you can put these “idiots” in jail, especially if his “criminal negiligence” is demonstrably profit driven. I also had occasion to discuss this with Bogle and he strongly supports the curative properties of retribution: it is an essential ingredient of the healing process and, until we get some, we will not heal and investor confidence will suffer. Pecora 2.0 was a dud. Let’s get on to Pecora 3.0. I am not holding my breath. I hope to watch 85 Broad St. being empied of its occupants carrying card board boxes with their personal effects. The world would be a better place.

5. Chris Whalen’s new book, “Inflated” is a fantastically easy and informative read on the history of monetary policy, debt, and inflation in the US. We are repeating history (go figure).

Mar 28 2011 at 1:39pm

Since 2008 I have been curious about the “fire-sale” argument but am still not sure how to test it. At a minimum, we would want to know whether assets purchased and held to maturity have turned out to be worth what the US Government paid for them at the time of the crisis. Has anyone looked into this question?

David B. Collum
Mar 29 2011 at 6:52am

I am guessing that there is no mechanism to look into how much the Fed retrieved from their purchase. There are so many three card monty approaches to pretending all is well. (Claims that GM is doing just peachy, for example, overlook the fact that they dumped all the garbage into GMAC, converted it to a bank (Ally Bank), and then bailed it out.) Here is how I think the Fed is doing: the assets they purchased are backed by a housing market in which there are an estimated 12 million empty units, untold millions in shadow inventory, a market that is up to its nostrils in a legal mess stemming from the MERS mess and frauds affiliated, and various moratoria on foreclosure as a result. One might ask rhetorically: How well do you think an mortgage-backed security could possibly be doing?

Mar 29 2011 at 11:26am

Great podcast with important insights/info from both Russ Roberts and Vincent Reinhart (not to mention the funny/disgusting lawyer in-joke tidbits).

However, it seems that in concentrating on Bear & Lehman, the role of AIG & its bailout is given, to my mind, somewhat short shrift. Of course, I think all the “naked “credit default swaps were the real danger during the Bear to Lehman days, so I would say that. Still, I hope Russ Roberts might at some point get an opportunity to discuss the AIG bailout (and perhaps “CDS as WMD” generally) with someone as knowledgable on that subject as Vincent Reinhart is about Bear and Lehman.

Thanks again (Russ, Rich, Lauren, others) for making this terrific podcast available for free. I tweeted that I loved it and hope you pick up a few new listeners.

Mar 29 2011 at 8:56pm

I’m pretty sure that the reference to a fire sale goes much further back:

Those Core classes at the University of Chicago are finally paying off!

Separately: good arguments all around. I was fascinated with the bit on off-balance sheets – I think this is a little-known, and underappreciated, fact.

Mar 30 2011 at 12:51am

I am a litte confused about a comment Vincent Reinhart made where he criticized the Fed for painting a rosy picture when the economy is doing well and preaching doom and gloom when it’s doing poorly.

Obviously doing the reverse (preaching doom in the boom years and cheeriness in the bad years) doesn’t make sense does it?

Even if you thought it was a good idea because the doom would temper the boom and the exuberance would minimize the dreariness of the recession, it seems these kinds of statements would be quickly ignored as formulaic or downright confusing.

D. F. Linton
Mar 30 2011 at 7:35am

Great podcast.

I also have a question about “fire sales” of assets. Reinhart said that the fear was that an asset would be sold below its fundamental value and that this would “destroy capital”. If I sell something worth $100 to you for $10, then my capital goes down by $90 and yours goes up by $90. Only if I carried the asset on my books at $200 would there be any reduction in book capital, but that already happened and the fire sale doesn’t change that.

Am I missing something?

David B. Collum
Mar 30 2011 at 2:50pm

You are not missing anything. It comes down to precisely who takes the losses and pockets the gain. It is quite clear that the Fed likes to pick winners (and de facto losers). Their choice to bail out the bond holders at non-market prices is an excellent illustration of who they favor.

Apr 1 2011 at 4:02pm

I was also wondering about inherent value along the same lines. (“fire sales” of assets…. fear was that an asset would be sold below its fundamental value and that this would “destroy capital”.)

However, since the dollar is not hard currency, and every transaction has a buyer and a seller, is it possible to destroy capital, or just to reassign value?

If I buy a house that has x dollars of materials in the construction of the house, then if I pay $5,000 less for the house than those materials “cost,” doesn’t that imply that the commodity market behind those materials should be depreciated accordingly, based on the labor and scarcity of the materials themselves? Or that the arrangement of those materials into the house is worth less than the raw materials themselves, based on how valuable that arrangement is?

Essentially, I wonder if there is anything real about the notion of inherent value.

Apr 4 2011 at 9:25am

The problem with “hanging up the phone on JPM or Bear and saying that’s capitalism” is a bit like the problem of free market health care. In other words neither really exists. We should move in that direction – unlike the direction we are moving but we weren’t in a perfectly free market in the first place. Deposit insurance took away the need for information on the creditworthiness of depository institutions, for instance.

Comments are closed.


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Podcast Episode Highlights
0:36Intro. [Recording date: March 14, 2011.] Paper in the Journal of Economic Perspectives "Year of Living Dangerously." The standard narrative of the financial crisis, which you challenge, is: The big mistake the government made that precipitated the crisis was the failure to rescue Lehman Brothers. But you disagree with that, and you go back to the March 2008 rescue of Bear Stearns, which by the way, I think we are on the third anniversary of to the day as we are taping this. Why do you think the Bear Stearns decision was so important? Bear Stearns set an enormous precedent. Lehman was made possible by the decision previously on Bear. Bear Stearns has many similar problems. It had seen to be in trouble for a while, so that you would have thought that the private sector had time to control their risk to bear. It was a firm that had a very illiquid balance sheet on the asset side, very short term liabilities. It was a classic run. The government--that is, the Federal Reserve with the consent of the Treasury, aided Bear Stearns. That built up the expectations that made Lehman possible. Let's go back to the history a little bit. I'm going to take you back a little farther when we get into more detail about the story. But let's go back to June of 2007. My understanding of the events of that month come from William Cohan's book, House of Cards, which I think is accurate; hasn't been challenged that I know. What happened was that in that month, two hedge funds, that Bear Stearns had been running, went broke. Yes--the wonderful name of Enhanced Leverage Fund--High-Grade Structured Credit Strategies Enhanced Leverage Fund--that's what I mean by saying the market got a hint that Bear was in trouble pretty early. In June 2007, it supported two hedge funds that really were holding the bits and pieces of its underwriting. They were very levered bets on housing. As those funds ran into trouble, Bear was unwilling or unable to provide enough liquidity support, and the funds decided to sell off some assets in an auction at the beginning of August. They held the auction of these very illiquid, complicated mortgage securities, and nobody showed up. Or rather, they had to stop the auction because the prices were so unattractive. That kind of gave you a signal that those highly levered, complicated securities supported by mortgages may not have the value that was currently thought in the market. The reason I mention William Cohan's account of that is that he details that Jimmy Cayne, who was the Chief Executive Officer (CEO) of Bear Stearns at the time, actually considered not honoring the promises that those funds had made to their investors, under the argument that that's a different part of Bear Stearns; true that it has our name on it, but those guys took their chances, paid their money; they were bad bets. They lost, not me--or not us. But ultimately the Board, in Cohan's account, convinced Cayne that that was not a wise strategy. Cayne, then used the parent company, Bear Stearns's money, to cover the losses of those hedge funds. That put Bear Stearns itself in a very precarious position. Is that correct? Yes, that's the story. And that is the precursor of much of what went wrong in 2008. All the entities that ran into financial problems actually satisfied their regulatory requirements in terms of having sufficient capital. The problem was twofold. Number one: Some of the assets they held were inflated relative to their true underlying value, and that difference got worse and worse as economic and market conditions deteriorated. But the second one is: Many of the entities had spun off activities, off balance sheet entities, that allowed it to keep a smaller balance sheet. So, the basic idea is you don't have to hold as much capital if you can create an off-balance-sheet entity where you hide some assets and liabilities. Regulators allowed that because it was supposed to be without recourse--that is, they were supposed to be independent firms. But the Bear example you gave shows you exactly what went wrong. When the crisis came, the management of the firm decided there were reputational risk, allowing an entity, even if it wasn't legally connected to the mother ship, to fail. As the crisis unfolded, all these big financial entities got bigger and bigger as they brought back their off balance sheet devices. That's a sense in which I'm willing to accept that there is some effect of the Glass-Steagall repeal on the crisis itself. Mainstream banks, like the Bank of America and Citi, which had these investment arms that were doing risky things with mortgage-backed securities could argue that that's a different part, but it didn't really turn out to be true. Right. I would say that would be an accounting, legal, and regulatory failure. The regulators didn't count the assets and liabilities of those off-balance sheet entities when determining the overall risk-taking of the mother entity. That was a mistake. When they approved it to begin with it was a mistake. When the auditors, lawyers signed off and said this is a vehicle without recourse, that didn't turn out to be the right determination. It was a bit of a fiction. When it failed--in September of 2008, Lehman according to some reports had 2000 separate entities under the same umbrella. And by entities you don't mean assets. Balance-sheet creations. That had assets under them.
8:18Let's go back to 2007. Summer 2007, there's a tremor that goes through the marketplace because these assets, very respectable names, Bear Stearns, the assets that they held, mortgage-backed securities, didn't seem to be worth very much. There were lots of firms doing the exact same thing. They all got a bit of a wakeup call. That became an alarm bell in March of 2008, when Bear Stearns realized they would be unable to borrow enough money on Monday morning of that weekend to honor its commitments to its creditors. Describe what the Fed did creatively over that weekend. We've talked about it a little in previous programs, podcasts. What did the Fed do? The first thing to remember is that Bear Stearns was an investment bank. It provided some services to the Federal Reserve Bank of New York--it was a primary dealer--but it was not an entity regulated by the Federal Reserve. Not an entity that the Federal Reserve could lend to legally through its standard discount window. The Fed facilitated the acquisition of Bear Stearns by JP Morgan Chase by taking off $30 billion worth of problematic assets. So, it did the economic equivalent of acquiring $30 billion of assets from Bear Stearns's portfolio, giving JP Morgan Chase $29 billion in return. That was enough of a sweetener to get JP Morgan Chase to agree to acquire the whole firm. The argument at the time was that they didn't have time to do the deal; they only had a weekend; it would be a disaster if markets opened on Monday and Bear Stearns went bankrupt. So, they didn't have time to evaluate the real value of those assets, JP Morgan said; so the Fed said: Okay, we understand, so we'll make sure that you bear no loss. They had to bear the first billion, but everything after that was going to be absorbed by the Federal Reserve. Is that a legitimate argument? So complicated. If you look at Hank Paulson's memoirs, you'll find the phrase that is repeated the most is: Before Asian markets opened. Bear was the first, but it happened again and again. Financial authorities believed that if they didn't resolve firm-specific uncertainty by the time Asian markets opened on Sunday night, that it would produce a dramatic sell-off of U.S. assets generally, as basically foreign investors, importantly including foreign official investors, withdrew from the dollar. There are a number of problems with this story, including the basic premise: That the Fed was only providing liquidity support. The assertion was there was value in those $30 billion of assets--indeed it was probably over-collateralizing lending $30 billion--it was just a matter of sorting through those individual assets to figure out the exact amount of value. So, in classic central bank fashion, the Federal Reserve would be lending into a crisis, when the market was temporarily illiquid, to a firm that was really solvent--the portfolio was really worth $30 billion. Now, there are a couple of things that are not classic about what the Fed did--namely it extended the perimeter of its safety net. Bear Stearns was a midsized investment bank. The Fed hadn't lent outside the commercial banks in volume for more than 70 years. It sent a signal about who it would be willing to support. Bear Stearns was a primary dealer, and so the Fed that same day threw its protections around all primary dealers, even though they weren't commercial banks, either. The Fed also structured the transaction to look like a loan, but it really had the economic equivalent of purchasing those assets. In a great irony, the Fed, in order to do that, had to create an off-balance-sheet entity. That entity was called Maiden Lane. To me, that is one of the best examples that you know lawyers have a sense of irony, because Maiden Lane is the back door to the Federal Reserve bank of New York. Lovely.
14:13So, they said at the time that they didn't have a choice; and they gave a number of justifications, one of which was Asian markets would panic and that might be bad for the dollar. They had other stories, too, right? There were multiple, sometimes conflicting stories, but you always have plenty of rationale for what you want to do. Was also a concern that if forced to liquidate Bear Stearns, there would have to be large sales of these problematic, mortgage-related securities that would drive down the prices of those securities and impair the balance sheets of entities similar to Bear. Second, that Bear Stearns was not alone; there were other entities that had balance sheets like Bear Stearns and that investors and market participants generally would extrapolate from the Bear experience and withdraw from those firms. That would be a source of contagion. And third, Bear Stearns was a direct counterparty to many financial institutions. If Bear was forced into bankruptcy and there were losses on Bear's portfolio then those losses would be shared throughout the financial community and potentially the machinery of finance would freeze up. Wasn't there a related issue that there would be delays in settling? The bankruptcy would get tied up in the courts; it would take a while; all these other firms that were expecting payments wouldn't be able to do anything. What do you think of that argument? I'm not convinced of it, but I think it's the best argument. To clarify: they held maybe thousands of positions, and on Monday morning they were going to owe money to people who then wouldn't get their money; they in turn were expecting that money and wouldn't be able to pay their folks. What's the legitimacy of that argument? Sometimes that's referred to as the flurry of faxes that would go out throughout Wall Street explaining that you'd not get prompt repayment, and that in turn would trigger all sorts of default clauses and significantly impair markets. The whole system would freeze up. I'm not sure what the next part of it is--the banking system wouldn't work. What does that mean when they say the whole system would freeze up? I don't know what that means for life on the street in a human setting. We heard it repeatedly in volume over the course of the year; by October of 2008, trying to convince Congress to do the Troubled Asset Relief Program (TARP), that banks and ATM machines would run out of cash. True? What does it mean to freeze up? The normal market participants withdraw from market activity because they don't trust their potential counterparty. Therefore markets don't clear, prices collapse; and that generally in the environment of very heightened attitudes toward risk, everybody hunkers down at the same time and it becomes a classic fallacy of composition--that each firm's individual effort to make its balance sheet safe, to preserve its limited cash, causes it to withdraw from market activity and then impairs the overall functioning of the markets. Ultimately that has a consequence for economic activity because a lot of the production and sales chain involves things like trade credit. And if banks are unwilling to make trade credit available then activity just doesn't get done. That sounds pretty scary. Among other things, it's a wonderful example of a false dichotomy, in which you present the listener with two alternatives: Either the Federal Reserve wisely steps in, sees that markets are trading at impaired prices, provides liquidity, and averts a return to the savagery of the previous world; or we are all dealing with going back to using cockle shells and trading cigarettes on street corners. We are given this either/or. The beauty of the false dichotomy is it directs attention away from asking the obvious questions: What were the middle things? For instance, was it possible to provide--distasteful as it might seem at the time--direct sweeteners to JP Morgan Chase for it to acquire Bear Stearns without setting the precedent of lending to a non-bank institution? Once it lent to Bear, the Fed then widened the entire safety net to all primary dealers and set this precedent of government intervention. So, were there other things that could have convinced JP Morgan Chase to buy Bear Stearns, including regulatory suasion. Were there other potential buyers of Bear Stearns? That was the unbelievable part of it--they gave them a very good deal. They were a little embarrassed by it, so they had to correct it at the last minute. The United States government played poker with Jamie Dimon. And lost. And went home without his pants. It wasn't really the government--it was you and I were playing poker with Jamie Dimon. We chose a representative and staked that person in this poker game, and we kind of regret it after the fact. The deal was so one-sided that a week later JP Morgan upped from $2 to $10 the price they were paying for Bear's equity.
21:14The part you emphasize, and that I've emphasized in writing about this: Yes, there was an indefensible expansion of Fed authority from a group of people who were not elected, whose accountability is very mixed--and by the way, we haven't talked about it and I've never seen it: What's the value of those $30 billion right now? We were told at the time we could even make money on it. By the way, we are the proud part-owners of a shopping center in Oklahoma City, and that is because one of the collateralized mortgage obligations on the Maiden Lane portfolio went into default and we got the property that was supporting it, namely a shopping center in Oklahoma; some hotels in Boston; and some in Colorado Springs. The Fed marks to market once a quarter. Its Maiden Lane portfolio, there have been losses; we've eaten through the billion dollars of protection. But you don't know offhand how much we've lost? It's on the H4.1 statistical release of the Fed. That would be a good thing to keep track of that. At any rate, the government went and expanded its authority, so we can complain about that. But here's the part that's so strange: They made sure that all the people that Bear Stearns owed money to, who were unsecured creditors--people who held bonds, who held other loans that had been made to Bear Stearns--they got all their money back, 100 cents on the dollar, because JP Morgan Chase took all of those over and honored them. Was there a way to structure that deal so that the people who had effectively financed the leverage that allowed Bear Stearns to make such bad bets could have paid a price for it. That's the part I think is the key. Do you have an answer to that? Were there alternatives, things in the middle of the false dichotomy that would have involved going to a private sector entity, having it list out its balance sheet, those troubled assets, but among other things allow it not to pay 100 cents on the dollar. Another time the Federal government or we elected to play poker with Jamie Dimon was in the FDIC's resolution for Washington Mutual, which, by the way did involve unsecured creditors taking haircuts. And who made that call? That was the FDIC. Kind of their thing, though in the past they haven't been so good at haircuts. I wonder why that happened. The FDIC's primary responsibility is to protect the insurance fund. So when it goes into a resolution, it really has to think, as instructed by Congress, of the least-cost resolution. It's actually difficult legally for the FDIC to get an exception to the least-cost resolution. The weekend of the WaMu resolution is quite instructive because there were two resolutions that weekend: there was Washington Mutual and there was Wachovia. Washington Mutual was run through the FDIC and there were haircuts. Haircuts means people didn't get everything they were promised--they get a fraction of it. Wachovia was facilitated by the Federal Reserve, and unsecured creditors got repaid.
25:30So, you were at the Fed for a couple of decades. Speculate, if you can, or you can demur--what do you think it was like that weekend in March? I have a slightly more sinister vision of the Fed. The Fed said they didn't have any choice; they could have explored some choices; but they'd say, well, we didn't have time. What do you think was really going on in the corridors there? How many times was Ben Bernanke's phone ringing? Who was calling? How much political pressure--and I don't mean the President calling and saying he had a lot of friends at JP Morgan--but it's a small world. Hank Paulson is an intimate of that world. Ben Bernanke was not, but he became one and has become one. It's a small circle of folks making these calls. Of course JP Morgan is going to tell the Chair of the Fed and the Secretary of the Treasury: If we don't get this result by Sunday night it's going to be an apocalypse. How do you think that played out? Before I answer that question, let me go back to the WaMu and Wachovia resolutions. Part of--if you are in the private sector--is knowing who to call in the government. Wachovia called the right entity; WaMu called the wrong one. I think that does reflect importantly on the charge financial authorities view themselves as having. FDIC's charge is to run an insurance entity and protect the insurance fund. The Federal Reserve is an entity that has an overarching mandate for financial stability. The Treasury also has that mandate and also, from the Secretary's perspective, has that unique responsibility of making sure it can always fund a very large deficit; that is, make sure when Asian markets open there are ready buyers. So, what basically happens--and I was not at the Fed at the time of Bear Stearns or Lehman. I was at the Fed at the time of the facilitated resolution of Long Term Capital Management (LTCM), back in September of 1998. I think the three things that highlight these crises, and at the outset, if you are not in the room, you don't know what's going on--there are all sorts of pressures, all sorts of time constraints, limited information; in some sense, this second guessing is unfair. But you asked me to be unfair and I will be. So, the first thing, from the Fed's standpoint is a delegation of authority. The initial point of contact isn't usually the Chairman of the Federal Reserve or someone working in Washington. It's the Federal Reserve Bank of New York. The person on the ground tends to be at a Reserve Bank. In 1998, that was Bill McDonough, right? Bill McDonough was at a BIS meeting in Switzerland, I'm pretty sure; and Peter Fisher, the Executive Vice President of the NY Federal Reserve Bank was the initial point of contact. McDonough came back. In 2008--you might recognize him, he came back--Timothy F. Geithner. He decided it was crucial. He must have spent some time with those folks. So, the first thing is there's a quorum periphery issue--that the point of contact is somebody working at a Reserve bank who probably views the financial institution they are dealing with as a client as well as a regulatory responsibility. How do you think the social interaction between those folks is? That's where I got to the client versus regulated entity. Up to 1980 one of the Federal Reserve's biggest problems was that its customer base was shrinking because banks were not electing to remain state-membered banks and therefore regulated by the Federal Reserve. There's a culture at Reserve banks--regulated entities are as much clients as regulated entities. Also remember that in these Reserve banks, they have a board of directors, and that board can include folks like Jamie Dimon, Dick Fuld, CEO of Lehman Brothers. So, when Reserve bank staff are dealing at a crisis, they are dealing with people they know. Not the best situation. The second thing is: incrementalism always sounds good. We know what we know; let's preserve that. How can we make small or even medium sized changes--if we can at least preserve what we know. The problem is there are some cases in which you can't get from here to there by making small steps. A good example of the incremental argument is Dodd-Frank, the legislation. It's reform legislation that is painfully obviously designed to keep every box on the chart unchanged. You may have to add new boxes, add new responsibilities, but you are working from what you know and moving, in my view, in the wrong direction. So, the second thing is the general view that small steps are better. The third thing is information asymmetries associated with multiple regulators. Nobody from the Fed really understood Bear Stearns. I would assume--it comes out in the tell-all books--they had to make phone calls to the SEC, who was the lead regulator. Trying to get information over the weekend about what their balance sheet really looks like. The answer is, in retrospect, the SEC was not fully informed about the balance sheet of Bear Stearns and the risks associated with it.
33:25Let's move on to Lehman. Something you don't talk about is that the credit default swaps on Lehman spiked very dramatically leading up to the middle of March. As soon as Bear Stearns was rescued--it gets very important; Bear Stearns wasn't bailed out--I mis-spoke. They weren't rescued. They were married off in a way that their creditors were rescued. Exactly. The unsecured creditors were rescued. And they are the ones who care the most about the downside risk. So the Fed sent a signal to the rest of the world that unsecured creditors don't have to be as careful as they might otherwise be. So you can complain about interventions, whether it's LTCM, Bear Stearns, Lehman and the decision at AIG for a couple of reasons. One is just pure execution problems. Was the firm really insolvent instead of illiquid? Did they consider alternative possibilities? Who knew what? Who was making the decisions? Did they have a sufficient understanding of the balance sheet and the consequences? The second problem with those sorts of interventions are the incentive effects. Unsecured creditors are the entities that are supposed to be providing discipline on the risk-taking of these large financial institutions. If you tell all potential counterparties that they'll be paid off 100 cents on the dollar, you are going to reward them doubly. They'll get a risk premium in the market for lending to these firms, and in the bad event, they'll get paid off by the government, or paid off in a facilitated resolution. So, you dilute the effects of market discipline. Those incentive effects are pretty serious. Heads I win, tails you lose, over and over again. Let's go to what happened at Lehman. We're going to look at what actually happened, and then we can speculate on what might have happened if the Fed acted differently. What did happen--I started to mention the credit default swaps, and those are the cost of buying insurance on Lehman Brothers--the cost of that went very high, and once Bear got bailed out, it went back to where it was before, which was much lower. For a wonderful example of incentive effects--immediately after facilitating the resolution of Bear Stearns, lending to a non-bank entity, the Federal Reserve extended its access to credit to all primary dealers. What is a primary dealer? A primary dealer is supposed to be a sophisticated participant in the fixed income market who has a business relationship with the Federal Reserve Bank of NY in conducting open market operations and in the auctions of U.S. Treasury Securities. Who are some of them? They were Bear Stearns and Lehman, but it would include Goldman Sachs, JP Morgan Chase, Morgan Stanley--lots of the very biggest names. And Bank of America. And Merrill Lynch? Yes. So, who isn't? At the time there were 20 dealers--they are the biggest, most sophisticated. A large, regional bank wouldn't be a primary dealer. Somebody like BB&T. So, Bear Stearns, a middle sized investment bank, also a primary dealer for the Federal Reserve Bank of NY, gets lent to to protect the unsecured creditors, the Federal Reserve then opens up its discount window to the remaining primary dealers. Which allows these primary dealers to borrow at subsidized rates--rates below what they would be able to borrow at in the market in a time of crisis. Hence, giving those entities a subsidy. And what happened? So, the week after the Fed does this--and then you have to ask what's the logic of doing this? The logic from the Fed's vantage point is you are protecting these entities to give them time to clean up their balance sheets. They can learn from the experience of Bear Stearns so that the system becomes more secure and less vulnerable. Now, what did Lehman actually learn from Bear Stearns? The week after the Fed sets this new precedent, Lehman took to gather the bits and pieces of its underwriting that remained on its balance sheet--all these really complicated tranches of these mortgage-backed securities, collateralized mortgage obligations, all sorts of instruments--and rolled them together and issued a new security. And that security had really one main economic purpose, which is it was eligible as collateral for borrowing from the Fed. So rather than cleaning up its balance sheet, they embedded risks even deeper in its balance sheet with this new structured security that really had no other customer than Lehman because it can serve as collateral in the discount window. So, they were active at that window. Now the beauty of that--the second indication that lawyers have a sense of irony--is Lehman called that structured note "Freedom Notes." That's good. It really made true that Kris Kristofferson song that Janis Joplin made famous, with the line "Freedom is just another word for nothing left to lose" [from "Me and Bobby McGee"].
40:35The other part of it--two pieces to this that I have suspicions about but I don't understand it and maybe you can help me. When Lehman did fall apart in September of 2008, one of the reasons it was seen as a catastrophe was that some of its creditors--at least one--was a money market fund, Reserve Primary, the first money market fund. One of the reasons interventionists the Lehman Brothers' decision to let them go is because the Lehman bankruptcy meant that Reserve Primary couldn't collect all the money they expected, so they "broke the buck"--the asset they had been offering was not worth a dollar any more but some fraction of that because now they wouldn't get all the money back from the Lehman loan they had made. As a result there was a fear that money market funds were at risk, fear that you wouldn't be able to get your money at the ATM, people went nuts. I think that day the Fed decided to--what, defend all Money Market funds? What happened was, I think, a belt and suspenders approach around those days. The Fed created a facility that essentially supported the value of the assets money market funds hold. The FDIC widened the safety net to include the liabilities of the money market funds. So the government supported the asset value then-guaranteed liabilities. Till then there had never been a guarantee of money market funds, but everyone just assumed that by definition they were only in safe stuff, they would never go down in value, you would always get your principle plus a little modest amount of interest. But it raised the question: What was Reserve Primary doing in investing in Lehman paper? The answer was, I assume: Well, it turned out okay for the people who invested in Bear Stearns' paper, and it paid well. You are going to win twice. You can offer a better rate of return than your competitors and in a worst case scenario, if Lehman goes bust, we'll get it back. So, in the event, the government ratified the presumption that investors made. By the way, in between Bear Stearns and Lehman was legislation to be able to resolve the two mortgage-related government sponsored enterprises (GSEs) Fannie Mae and Freddie Mac. And the hallmark of those resolutions was making sure that all creditors were paid 100 cents to the dollar by the U.S. government even though every single underwriting document that Fannie and Freddie ever had, said at the top: This is not an entity of the U.S. government; these are not guaranteed by the U.S. government. They did not draw in the semicolon and the parenthesis ;) , which in email means winking; they actually just stated it; it was in capital letters. The other thing I've seen everybody discuss, don't know how important or true it is: but when I looked at Lehman's bankruptcy filing, its largest creditors in that filing were overwhelmingly Japanese and Asian banks. I know that Bear Stearns' creditors--I don't know exactly who they were but I know that JP Morgan was a big creditor that had expectations of payback from Bear Stearns, which of course the government made sure that some of that was not going to have to be worried about. What do you think of this political economy argument, which says that the reason that Bear Stearns was rescued is they were politically very important, but the creditors of Lehman were not? And this whole argument of "too big to fail" is just a smokescreen? Lehman was treated differently than Bear Stearns. Even though when you think about the arguments they seem to have a very similar experience. Similar balance sheet risks, counterparties that matter. One is tempted to believe that personalities matter as well--the history of the Secretary of the Treasury at the time--with Lehman maybe was influenced. There was a frantic attempt at the end to find a suitor akin to JP Morgan Chase. The likely candidate for some reason was Barclay's Bank. They asked, not unrealistically, for the government to do for them what they had done for JP Morgan Chase. The government said no; Lehman collapsed; and then Barclay's bought up a bunch of Lehman that they were going to buy anyway. Going back to the argument of the false dichotomy--what was in between? It just has to say something about crisis management. There was six months between Bear Stearns and Lehman. But you read the tell-all books and there is this last-minute frantic rush to find an appropriate suitor. What were we doing between? It's not in the tell-all. I guess it's tell-some or tell a little bit. When you look at Bear, the GSEs, Lehman, and AIG, these are informing the structure that the government now wants in terms of the financial stability oversight, enhanced resolution powers, in order to wind up large complex financial institutions. I look back at 2008 and there are a number of criticisms you can make. We made the execution ones already: solvency versus illiquidity, we made the incentive effects ones. But in the end I think there's a plain old impossibility proof here. The normal justification for lending to a levered entity--an intermediary--in a time of stress makes it almost a free lunch for the government. You have worried depositors who will run because they recognize that the assets the entity holds cannot be liquidated in sufficient time to pay them back 100 cents on the dollar. That's the illiquidity claim. In the classic example, going back to Bagehot and Lombard Street and made mathematical by Diamond and Dybvig in the early 1980s, and as presented by our Chairman of the Fed and Secretary of the Treasury, here is a role for the government. We have intermediaries holding illiquid assets, providing an important economic function, supporting spending and production. Their chief liabilities are short term, and therefore they might be subject to runs because they can't liquefy those assets quickly enough. This is the government as lender of last resort argument. So therefore if you step in and just reassure everyone that you will protect them in a time of duress, then there is no reason ever to run.
49:18That presumes that you are never tempted to provide lending of last resort when they are insolvent, when the underlying assets are not good. Bagehot's book--online at it's okay for the government to lend money to illiquid organizations but not insolvent ones. Your point really is that the political economy is always going to push you to identify them as illiquid rather than as insolvent. Phrase used repeatedly in 2008, which is: Government interventions were preventing fire sales. That is, if you force the financial institution to liquidate, it would be selling impaired assets into the market all at once; the prices would go well down below fundamental value and there would be capital losses that wouldn't be there if the assets were just held to maturity. Chairman Bernanke was talking about held-to-maturity values versus fire-sale values. That's the problem with mark to market--if forces these firms. Now, in the same symposium in Economic Perspectives, Schliefer and Vishny have a paper in which they have a paragraph or two on the history of fire sales; the term "fire sale" comes from the 19th century that involve the sale of fire-damaged goods after a fire. So, those prices will be significantly discounted relative to market. My response to that is: If it turns out that the market price of fire-damaged goods is very low, how do you really know that says something about market dynamics, or that they are damaged by fire? Not very good, not worth very much. The other part of the example of fire sales is: if you talk to an insurance agent, you find out that the majority of damage associated with a fire is actually from water. It's how we do the crisis management. So, we have this presumption that government intervention is almost a free lunch, because there is this market failure; there would be fire sales if you had to liquidate the firm; the Fed or the financial stability oversight council can wisely step in and prevent those firesales, therefore meaning there won't be a deposit run. But what they forgot, that we saw over and over again in 2008: these large institutions have lots of different traded assets related to their value. The playbook of intervention is: if you've decided to help a given financial firm, you will protect unsecured creditors so they don't run, and you will wipe out equity holders. So why don't you just pick the next firm in which the government will intervene, short the equity, and buy the unsecured debt? You, meaning an investor. You make the problem even worse. The fact that government stands ready to help in the resolution of the firm doesn't stop the incentive to run. It doesn't stop market speculation. It doesn't stop the strains in financial markets. It may put them in different places, that's all. Can't help but quote Hayek: The curious task of economics is to illustrate to men how little they understand about what they imagine they can design. There's no end to the attempts to tweak and fiddle and use the levers of the system to try to get to the ends you want.
54:09Let me make a complaint about this narrative. You correctly point out that in 1998 it wasn't a Fed rescue--a lot of people like to portray it that way. It was a coordination, orchestration that the Fed was going to do something for non-commercial banks, hedge fund in that case. I think that did send some kind of signal, not as dramatic as the Bear Stearns story. But if you go back to 1995, you get the Mexican crisis, where the U.S. government guarantees $50 billion of Mexican loans under the same argument that markets are going to blow up. What they really did was protect the creditors of Mexico. That story has not been fully told, but we understand that some of them were U.S. investment banks. You go back to 1984, you have Continental Illinois. You have the Savings and Loan crisis, where numerous uninsured creditors were made whole, almost 100 cents on the dollar every single time even if they were above FDIC insurance limits. My potential footnote to your story so far is that I think this larger pattern of creditor rescue made it easier for Wall Street to go public, more tempting for these investment banks to go public, and helped sow the seeds for this long before 2008, even before 1998. What do you think of that argument? I agree completely. I would say a couple of things. I wrote a piece for our online magazine,, called "When They Were Young." Basically pointed out, if you look, this was in 2009, the officials in the Obama Administration were actually all part of the Committee to Save the World during the Clinton Administration. Including involved in the Mexican rescue or bailout and the Asian financial crisis. And so, look to the 1990s to see the ways they think. Among other things, you see use of the Exchange Stabilization Fund (ESF) as evidence that the government actually has a lot of off-balance-sheet entities. And at a time of crisis, they'll be happy to use an off-balance-sheet entity. The Fed happens to be off balance sheet. In 1998, in the Asian financial crisis, what is looked back on and actually with some pride is that the President of the Federal Reserve Bank in NY actually strong-armed banks over Korean debt. What exactly happened in, say, the events around General Motors (GM) and Chrysler bank obligations? The 1990s give a lot of pieces of evidence. Avoid Congress, use the off-balance-sheet entities, use leverage on regulated entities. And that's where we are. Indeed, Dodd-Frank legislation legitimizes all those uses of power. It's the triumph of discretion over rules. No doubt about it. So, the one thing--the point I was making about Bear Stearns--it added the Fed to the club in a way that prior to that, the Fed was always seen as the independent arbiter. And the Fed lost that ability. Very good point. The only thing I would add is that those decisions in the 1990s, the participants crowed about them, because they didn't cost the taxpayer a cent. The $50 billion dollar guarantee of Mexican credit never was invoked, so therefore it was a free lunch. It was another free lunch story, so therefore it ignored the incentives. Blew up in our faces a few years ago. So, you have the incentive effects for sure. But I think when you are dealing with large, complex financial institutions, it just may be impossible to resolve the way they think you can. There isn't a free lunch. No matter how hard Hank Paulson worked each weekend, there was another firm in trouble the next week. The way I put it at the time: the next weakest antelope in the herd. Yeah, exactly. If you have provided a blueprint of how you are going to resolve entities, protecting some portion of the balance sheet, wiping out another portion of the balance sheet, that's a blueprint to speculate against the firm. That's a great point, hasn't been made.
59:34Counterfactual of what might have been different. Let me phrase this as a challenge to your story and implicit a challenge to my version as well. You argue, I agree, a mistake: in March, they should have let Bear Stearns go bankrupt. Wouldn't have been as catastrophic; wouldn't have had this expansion of Fed authority, wouldn't have had a signal to all the participants that all this leverage of financial activity that they've been doing was going to lead to trouble. We'd already had the signals that all the assets themselves were worse than people thought. Part of me says: Well, it was too late. What could Lehman really have done? If the Fed had let Bear go down and hung up the phone on JP Morgan Chase and said, Live with it, that's called capitalism. Which I would have liked. What could Lehman and all the holders of these, at AIG and these other folks, Fannie and Freddie? The handwriting was already on the wall. True, for the next six months they pretended it wasn't; they hoped for a miracle, they hoped housing prices would rise again and they'd be bailed out again effectively by the Fed's behavior. Could they really have done anything? First of all, let me say I don't think it would have been pleasant. We built too many houses as a nation. That's a whole different story about houses and support and subsidy. But we did. But when we realized how many houses we had, that there had to be a price adjustment. There was a real economic loss. Financial markets recognized the economic loss. They didn't damp it. Why didn't they damp it? Part of it was the incentives the government provided for them to twist their balance sheets, make them way more complicated and intricate, so that part of it was crisis management. On one level you are right--you bought into the false dichotomy. You said: If the government said, if the NY Fed, whoever was the main actor in the week three years ago from when we are talking now, had said: Just don't come to us--it is possible that Bear would have moved into bankruptcy and we would have had a rippling of these losses. But it's also possible there would have been intermediates. Remember, going back to LTCM, the Fed facilitated a resolution. It also meant that Warren Buffett--who was willing buy the portfolio of LTCM, didn't get that opportunity to add to his billions. In a fire sale, he could have made a big profit opportunity. He was on the phone. Supposedly, the folks at LTCM said no because they thought they'd do better from a Fed-facilitated resolution. So, three years ago, would have been a forced bankruptcy of Bear and all the ripple effects possible. But what would have been all the intermediate steps? There could have been had participants been assured they didn't have the backstop of the government. So that we will never know. Would there have been failures? Yeah, and it would have been possible the Fed would have had to open up its discount window, provide huge support to markets in the form of big injections or reserves. But we would have had more clearly-defined lines drawn.
1:03:20The other part, and I don't know the answer to this, is that Lehman wouldn't have issued that security that you mentioned earlier. It wouldn't have been able to borrow from money market funds, and the damage would have been smaller. I don't know if it would have been non-existent, as you point out; I don't know if it was unavoidable, because there was a reality there; people had a bunch of assets that weren't worth what they hoped they would be worth. That part you can't change. One other piece of the puzzle is that Lehman did go bankrupt. A lot of people said: Look how horrible it turned out. They are pointing to the market signals that followed that. You have argued--I agree; John Taylor has argued--those signals occurred because an expectation wasn't realized. It wasn't the inherent destruction of Lehman that was unhealthy. It was people realizing: Oh, my gosh, they are not going to be able to sell? But we also got a bunch of data on what happened to their counterparties. And that has gone to the courts. Again, very few people have reported on it, but the world didn't come to an end because Lehman Brothers got tied up in the courts. Did we learn anything from that? Bankruptcy does work. If we are thinking now, are there ways of simplifying balance sheets to make the bankruptcy process easier and more transparent, we might be much better than making the financial system more intricate as we are doing with Dodd-Frank. Had Bear Stearns gone bankrupt--there wasn't in the end an alternative, it went into bankruptcy--we would have a severe macro dislocation. The Federal Reserve would have had to provide resources to support markets; but it would have been to support markets not to individual institutions. And the bankruptcy would have gotten resolved. How much sympathy should we have for unsecured creditors who had seen nine months' worth of trouble, with the assets that Bear Stearns was the underwriter of? What other chickens are going to come home to roost? The other part of this is of course that along the way the Fed has acquired much of the balance sheets of the government sponsored enterprises--Fannie and Freddie; we are going to lose a lot of money of those. What else is going to happen? I think we also have impaired the Fed's role as a macro stabilizer. If you think back, the amazing thing to me of September and October of 2008 was how the financial shock got transmitted into confidence. But what was happening in September and October of 2008? Our chief financial officials--the people we look to for guidance on the macro-economy--were telling Congress we were on the edge of a precipice. That they had to pass the Troubled Asset Relief Program (TARP). They had to give more resources to double down, to support what could be many failing institutions. And what happened? Every single measure of confidence, every single measure of sales intentions, it just fell off a cliff. That, when we give this role for financial stability, explicitly, it means we really do impair the information content on their description of the economy. In normal times, they are always going to say the financial system is sound. And therefore we are going to believe them less in the stabilization of the economy. In hard times they are going to tell us how important it is, and how many unusual steps we have to support financial stability; and we are going to get more worried about the economy. So, if Ben Bernanke, Tim Geithner, and Hank Paulson were sitting opposite you in this panel, what would they say in disputing you, and why should I believe you? I think they would say they sincerely believe they are on the eve of a precipice; that the financial system is extremely nonlinear; that there were adverse effects on confidence, a drawback of representative democracy. And what would I say? I would say you shouldn't have been in that position to begin with. That indeed they made decisions upstream that had these huge consequences in the flood plain; and the flood plain turned out to be September, October 2008.