fresh voices from the front lines of change








All done. Lesson: Break Up The Banks.



Most of the discussion surrounding too-big-to-fail at this hearing has dealt with a relatively short period in time: the decision to bailout a firm, and what happened right after that decision.

This is an important part of the issue, but it's by no means the whole story.

Right now, three banks control 55 percent of the mortgage market, while 10 banks control 95 percent of it. Banks this large, with this much control over the financial spectrum are impeding normal market functions. Even if we allowed these megabanks to fail, the current system is fundamentally anti-competitive, and the broader economy pays a significant price for it. Loans are more expensive because banks can force higher prices on the rest of the economy due to their market clout. Those higher prices do not create any economic benefit for the broader economy-- the exact opposite is true. Big Finance is eating away at the real economy, hamstringing businesses, hampering innovation and making people poorer in the process. That would be bad even if policymakers could credibly say they'd allow Citi and JPMorgan Chase to fail. Which they can't.



Georgiou just asked her point blank if, given everything that went on in 2008 and 2009, the resolution authority for complex financial institutions is at all credible. Bair said yes. Bair can credibly say yes because she wanted to apply the resolution authority to Wachovia, because she didn't think it would result in a systemic nightmare.

I think Bair is living in fantasy-land here, but unlike every other major player from 2008, she is at least consistent.

But remember, even if Bair was ultimately right that bailing out Wachovia bondholders was unnecessary, its not the whole story.

When it went under, Wachovia was a commercial bank with about $700 billion in assets. Citigroup, Bank of America and JPMorgan Chase all have well in excess of $2 trillion in assets, under dozens of different lines of financial business. They have massive derivatives operations and lots and lots of complex securities trading. From a strictly technical standpoint, these megabanks much more difficult to unwind than a bank that does almost nothing other than accept deposits and extend loans.

And this ignores Bernanke's admission that it will be impossible to unwind banks across international boundaries.

We may not be able to end too-big-to-fail. In the past, the U.S. has chosen to subsidize the creditors of banks much smaller than Wachovia. Since the Reagan era, the top banks have all been given special treatment. But the price and the consequences of subsidizing creditors in the 1980s were vastly smaller than those of the 2008 and 2009 bailouts. Breaking up the banks at least gives regulators a fighting chance to shut down our largest banks when they fail. If breaking them up isn't feasible, the cost of bailing out a $50 billion bank is a lot lower than the cost of bailing out a $5 trillion bank.



Holtz-Eakin just made a great point. Prompt corrective action laws lay out a set of binding, concrete steps that bank regulators have to take when banks get into trouble, staring with restrictions on bank activities and, if the bank is unable to raise enough private capital, ending with liquidation. Regulators do not have the discretion to inject taxpayer money into the bank to keep it afloat.

But the stress tests, of course, sidestepped these laws for the 19 largest banks. Treasury injected capital into these banks and ignored the codified process for reining them in.

Bair responded that the stress tests were a commitment to keep banks above the capital thresholds where prompt corrective action would have applied. Geithner said this repeatedly when the stress tests occurred, and it's totally absurd. It requires us to believe that banks really are perfectly healthy, but the government has to inject capital into them anyway. If the banks really were healthy, why on earth were taxpayers asked to stand behind them?

This is, of course, a technical legal note that keeps policymakers out of jail. But as Holtz-Eakin notes, regardless of what happens to policymakers, the signal to financial markets is absolutely clear. When things break down and crisis sets in, the law doesn't apply. Whatever Congress puts on the books, regulators will do whatever they think is necessary to save the system when the system breaks down.

That does not bode well for the new requirements Congress just imposed on regulators for shutting down "systemically important" firms.



Bair says she never knew that the IRS was planning to restructure tax code. Also says she was surprised by Wells Fargo's competing offer for Wachovia.



Angelides is digging into the dispute between Bair and Geithner (then at NY Fed) over whether Wachovia creditors should have been fully protected.

Bair is not a perfect regulator and she wasn't perfect on Wachovia, but unlike just about everybody else running the regulatory, she actually respected the laws on the books and actually wanted to see creditors and shareholders take losses.

She wasn't totally sold on invoking a systemic risk exception for Wachovia, because she wanted to hit Wachovia's bondholders with losses. It's been clearly established for decades that commercial bank bondholders take a hit when commercial banks fail. Depositors are protected, other creditors have to deal with the consequences of failure, and they've always known that.

Geithner wanted to protect bondholders, and you protect bondholders by either bailing out the bank or by arranging a merger. The systemic risky exemption which allowed the FDIC to act outside some of the prompt corrective action mandates came from Geithner. Bair resisted, but ultimately gave in.

Geithner may actually have been right about bailing out Wachovia bondholders. It may have been systemically critical to shield them from losses (although if it was, it probably wasn't necessary to shield all bondholders from all losses).

There's an obvious lesson to this episode, and there's really no excuse for Geithner failing to learn it, given his role in the mess. Resolution authorities do not work for big banks. Even under the most generous interpretation of Geithner's actions on Wachovia, one has to conclude that in a crisis, big bank investors need to be subsidized, whether there's a legal structure that prevents this subsidy or not.

Let me emphasize this: Geithner was the very person demanding that the resolution authority be ignored for Wachovia. But his policy for ending too big to fail? Expanding the FDIC's resolution authority to new types of financial firms.

Break up the banks.



Bair is beginning.



Capital requirements only matter if you actually apply firm accounting standards. If you let banks account for their assets however they want to, they don't have to take losses, because they can simply invent profits and erase losses on their balance sheets, irrespective of what's going on in the real world.

This is why stronger capital requirements alone are unlikely to help in the next financial crisis. Bank accounting is generally a flexible enterprise, and regulators allow banks to get away with murder when financial crises hit. This time around, they went so far as to formally reinterpret accounting rules that required banks to account for their assets at their current market value. That sounds crazy, and it basically is crazy, although there are some crazy people who think market-based accounting was actually what caused the financial crisis, not any fundamental problems on Wall Street.

In response to a host of questions about capital requirements Bernanke basically cautioned against getting too aggressive with new standards, and also cautioned against getting too stringent with accounting guidelines. This stuff is hard, you don't want to screw up, but I believe in markets, and mark-to-market accounting is useful, etc.

The problem is, Bernanke's reticence here is fundamentally anti-market. He's saying that if we pay too much attention to markets in a time of crisis, asset prices will go down too much and banks will be in more trouble than they need to be. If we give banks some flexibility on accounting during a crisis, they won't have to take immediate losses, and once asset prices rebound from their panic-driven lows, everything will be okay. It just means that marking to market is good, so long as market prices are high. When market prices are low, we're somehow being unfair to banks by making them recognize those low prices.

But even if Bernanke is right, and there is something fishy about mark-to-market accounting during a financial crisis-- what's the alternative? Letting banks make up whatever asset values they want? That was the plan in 2008, and it's still the plan today, especially on second-lien mortgages, which banks continue to value at hundreds of billions of dollars, even though second-liens are worthless once home prices decline.

Over and over and over again we've heard Timothy Geithner and Alan Greenspan and Ben Bernanke say we need higher capital requirements. But nobody has any plan for actually enforcing those standards.



More on the legality of the Wachovia arrangement. There are some loopholes in the prompt corrective action process, and the FDIC did invoke a systemic risk exception so that it didn't have too dump Wachovia's assets at the least cost to the taxpayer.

But Bair was still planning to auction off Wachovia's assets before Treasury changed the tax law to facilitate the Wells Fargo deal. And no matter what happened, if there was even uncertainty about whether Wachovia was solvent, the OCC totally failed to enforce prompt corrective action laws in the run-up to the bank run. There are multiple categories of capitalization, Wachovia was at the highest. When you slip down into weaker categories, regulators are required to take actions which the OCC did not take.



Did Bernanke just admit that the Wachovia bailout was illegal? Wallison is now pressing Bernanke on the same liquidity stuff he presented yesterday to NY Fed's Baxter.

The discount window should be able to provide unlimited liquidity to any solvent bank. It's supposed to help deal with bank runs. If the bank can put up collateral, it can get a loan from the Fed, and the run won't kill the bank.

When Wachovia failed in 2008, regulators blamed a liquidity run (as they did for IndyMac and other banks that failed that year). But that's not supposed to be possible. So, Wallison asks, what happened?

"Their liquidity demands were such that they thought they could not meet them even with the discount window," Bernanke said.

Wallison pushed back. Really? They were solvent but they didn't have the collateral to get loans from the Fed?

Then Bernanke half-admits what must have been going on:

"I think there was uncertainty about whether they were solvent or not," Bernanke said.

This is a very big deal, because the regulators had clear, well-defined authority to unwind Wachovia. It wasn't an investment bank like Lehman Brothers, it was a commercial bank like Washington Mutual. Not only that, under prompt corrective action statutes, regulators and a clear, well-defined legal obligation to shut down Wachovia if it was in fact insolvent. In fact, they had a clear, well-defined responsibility to shut down Wachovia before it became insolvent in order to protect taxpayers. Instead, policymakers arranged a complex bailout by abusing the tax code to subsidize Wells Fargo's acquisition of Wachovia.

If Wachovia was insolvent, this was not just reckless policy, it could have been illegal.

There are accountability questions here-- investigations? prosecutions?-- but also systemic regulatory questions. Even if the new resolution authority for megabanks is technically feasible, can we realistically expect policymakers to use it after the Wachovia mess?



Bernanke: "Regulation alone is not going to be enough."

That's a stunning admission. The whole purpose of the Dodd-Frank bill is to grant regulators broader authorities to crack down on financial excess. It does not significantly restructure the financial system in order to realign market incentives. The major structural reforms-- breaking up the banks, reinstating Glass-Stegall-- were rejected in favor of tighter rules on the existing structure.

This was not an accident. The Fed and Treasury pushed very hard against efforts to change Wall Street's structure. Now that they've successfully limited the bill to a set of (potentially useful) regulatory tweaks, Bernanke is saying that we can't expect too much from regulation.

Bernanke is trying to manage expectations. When the next financial crisis hits, don't blame the Fed.



Douglas Holtz-Eakin is pressing Bernanke on the list of "systemically important" (read: too big to fail) firms that the Fed will be responsible for overseeing. This is an important issue-- the Dodd-Frank bill requires the Fed to compile a list of these firms and place more stringent regulations on those firms than the rules that apply to everyone else. It's one of a handful of half-measures involved in Dodd-Frank designed to prevent a Lehman-like situation again. The idea is that by subjecting megabanks to tougher rules, they'll be less likely to fail.

It probably can't work, since banks will still have distorted risk appetites and funding advantages, and the Fed is not exactly a tenacious regulator. But Bernanke is already downplaying the importance of the list. He just emphasized that the FDIC will have the authority to unwind any failing financial titan, whether or not they make the Fed's list. The list isn't really the important thing, in Bernanke's mind, what's important is the resolution authority.

In other words, the Fed is already trying to shirk responsibility for Too Big To Fail. If the Fed gets the TBTF list wrong, it's not really their fault, because the FDIC is the agency that is supposed to handle the real trouble. If the Fed gets the list right and doesn't regulate effectively, well, it's still on the FDIC.

Very discouraging.



So we finally get to what this hearing is supposed to be about: Too Big To Fail. And it's ugly.

Bernanke just said it will be very difficult to unwind a large financial institution across international borders.

No kidding. Look at what's happening to Moody's right now. The SEC has decided not to pursue fraud charges against the rating agency on the grounds that it does not have the legal authority to go after its operations headquartered overseas. The SEC has new authorities to go after fraud abroad under the Dodd-Frank bill-- they'll be able to impose fines against the U.S. operations based on improprieties committed overseas.

But nothing gives any regulator the authority to liquidate assets abroad. No U.S. law can do that. Bernanke has been arguing for years that breaking up the biggest banks is not feasible, and a new legal resolution mechanism to shut down failing firms will be sufficient to deal with Too Big To Fail. For just as long, Simon Johnson has been saying that a resolution mechanism can't work, because it will run into international law hurdles. Bernanke just admitted Johnson was right. Very polite of him to wait until the Wall Street reform bill to be signed into law.



Georgiou goes after securitization. What should the Fed do to align incentives of the securities market participants with those of the original lender who actually extends a loan?

"There should be a longer horizon, not just whether you made the sale or the deal, but how it worked out over a number of years," Bernanke responds

We'll see if the Fed actually does that-- most of the "skin in the game" requirements have been extremely weak, and the Fed hasn't exactly been their strongest champion. Can you really imagine them cracking down meaningfully on banker pay? Remember who runs the Fed. JPMorgan Chase CEO Jamie Dimon is on the board of the New York Fed. BB&T CEO Kelly King is on the board of the Richmond Fed. Think these guys are going to sign-off on a pay cut?

Moreover, getting incentives right is only part of the answer. But something has to be done about the sheer volume of speculation involved here. Even if the incentives are straight, having dozens of bets placed on every mortgage results in a tremendous and inevitable mountain of losses if that mortgage goes bad. Some of this will be assuaged by the new central clearing regulations included in the Dodd-Frank bill. But the continued existence of naked CDS remains a significant threat to



Bernanke calls the Fed's failure to regulate the subprime mortgage its "most significant failure" of the past decade.

Probably true. But would the Fed Chairman be regretting this failure if mortgage problems had not spawned into a monstrous financial crisis? Consumer abuses aren't necessarily systemic problems-- usually abusive behavior is great for banks, it means easy money.

Nomi Prins calculates that only $1.4 trillion in exotic mortgages were issued during the housing bubble-- nowhere near enough to crash the global economy. It's the securities and the derivatives concocted from those mortgages that created such a massive crisis. Imagine a $1.4 trillion mortgage crash, but one with no corresponding securities implosion. Wall Street takes some losses, sure-- a couple of big commercial banks might even fail-- but there is no disaster.

In that scenario, I imagine Bernanke & Co. simply washing their hands of the consumer catastrophe. "See," they'd say, "The unregulated marked worked! The banks that issued these bad mortgages took a beating and learned an important lesson, and the financial system effectively regulated itself without government intervention." The fact that millions of homeowners had seen their life savings decimated by predatory lending wouldn't matter to them.

That's why the CFPB appointment is so important. The Fed will only care about consumers to the extent that consumers are linked to the survival of megabanks. A weak CFPB Director would be overrun by the bank-friendly policymakers at Fed and Treasury, and consumers would get screwed. Elizabeth Warren is the only candidate for the post who has demonstrated a willingness to stand up to the financial status quo in defense of working families, and what's more, she's always been right on the issues she's taken a stand on.




"I believed deeply that if Lehman did fail or was allowed to fail, that the consequences . . . would be catastrophic . . . "The unanimous opinon . . . was that Lehman did not have enough collateral to lend against . . . it wasn't just a question of legality, it was a question of whether there was anything we can do."

Then he says that there was no discussion about whether they should bail out Lehman or not-- everyone at the Fed who talked to Bernanke really wanted to bailout Lehman, but just couldn't find a practical way to do it.

That's ridiculous. And what's more, it doesn't make the Fed look very good. No discussion of whether to bail out Lehman or not? Why wouldn't you have that discussion? Isn't it an important question? The critique of allowing Lehman to fail is not that the Fed deliberated too long, but that it deliberated and came to the wrong conclusion.

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