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Clearly the best FCIC hearing to date. Tough questions all around. Everybody comes out of it looking bad, bankers and regulators alike, as they should.



This hearing is full of surprises. Peter Wallison just presented a very productive set of questions to NY Fed’s Baxter. The discount window is supposed to protect against liquidity runs. Banks don’t fail due to liquidity constraints because the Fed will lend them money against solid collateral. If banks don’t have solid collateral, they’re not just suffering from a run on the bank, they have a capital shortage. That’s solvency, not liquidity.

But policymakers have said that for both Wachovia and Lehman, the proximate cause of failure was a liquidity shortage. This should be impossible, as Wallison notes. By the time Lehman failed, the discount window had been opened to investment banks, so both had access to unlimited Fed liquidity, provided they could put up collateral.

But both of these banks went under. So Wallison asks: Were these banks insolvent?

It’s an important question, because if the bank was insolvent, transferring taxpayer benefits to its shareholders is totally crazy– particularly for Wachovia, where clear legal authority existed to shut the bank down.

Baxter dodged on Wachovia, saying he didn’t know anything about Wachovia because they aren’t in the NY Fed’s district. On Lehman, he said that the NY Fed needed formal approval from the Fed Board of Governors. Baxter says that makes no sense, because it would have been “lending to the parent in the midst of a run” and “a bridge to nowhere.”

That’s a totally deceptive dodge. The Fed lends to banks in the middle of bank runs all the time. That’s the whole point of the discount window. That lending is only “a bridge to nowhere” if Lehman is insolvent and can’t pay it back.

So why doesn’t the Fed want to acknowledge that lots of banks were insolvent in 2008? Well, the entire strategy for rescuing these banks was sold to the public on the premise that banks were not short on capital, just liquidity. If we kept them in business long enough, sanity would return to the market, asset prices would rebound, and everything would be okay.

That didn’t happen. The assets were actually lousy. The only thing propping them up today is the government’s willingness to accept artificially inflated accounting values, rooted in the stress tests from February 2009. Policymakers don’t want to admit that they knowingly subsidized shareholders and executives when it made no sense to do so. Policymakers have subsidized the creditors of failing banks for decades, and at times it has been really offensive, but it’s not abnormal. Creditors don’t necessarily take a hit when a bank is insolvent. If there’s enough money there, they just become shareholders and don’t have to take losses. But shareholders are always gone.

So Wallison has just emphasized that policymakers were smart enough to deny liquidity support to banks they knew to be insolvent, but then went around telling everybody the only problem was liquidity. At minimum, it’s dishonest policy. At worst, it’s crony capitalism.



It’s always satisfying to watch Brooksley Born question people on derivatives. There’s always some exchange like this:

“Were derivatives a big part of the reason Firm X failed?”

The answer is always “Yes.”

“Is the accounting for the Firm X derivatives book suspect?”

The answer is always “Yes.”

The implied question, of course, is:

“Did the global economy pay a devastating price for my vicious marginalization in the late 1990s?”

The answer to that question is also: “Yes.”



Interesting point from Angelides. On Sept. 24, 2008, Bernanke testified to Congress about the Fed’s actions in Lehman. But he never mentioned the legal authority to intervene in that testimony. Since then, it’s become the central tenet of the Fed’s defense. Hmm.



Wow. The bankruptcy examiner just said the Fed was totally wrong about Lehman. There was in fact collateral available that the Fed could have accepted in exchange for an emergency loan. The Fed could have acted, according the bankruptcy examiner, but chose not to.

Lehman still put itself in the position where it needed to be bailed out. You can’t lay all of the blame on the Fed. But remember that the general line on Bernanke, for instance, when Obama reappointed him, was that the Fed had done a good job rescuing the financial system. Sure, he and everybody at the Fed had allowed a huge housing bubble and an enormous financial crisis to develop, but once that crisis got underway, they did everything they could to keep it contained, and did a good job.

There were already cracks in that armor when we learned about Geithner’s pathetic negotiations on AIG. But the Lehman bankruptcy examiner is now saying that the Fed had a lot of options on Lehman, and simply chose not to pursue them. There may have been good reasons not to pursue them. Fuld, certainly, was asking for trouble. He refused to accept a last-minute merger deal because he thought the government would bail him out. That’s inexcusable, and there is a real moral hazard consideration to take into account when you see an executive do that.

But the Fed could have bailed out Lehman and discharged Fuld as a condition of the bailout. The Fed didn’t do that. It could have bailed out Lehman, wiped out shareholders, and imposed losses on creditors as a condition of the loan. The Fed didn’t do that.



Lehman’s Fuld says Fed told him Lehman would be barred from the discount window. NY Fed’s Baxter says it’s not true, and Lehman had it in writing that they could access the discount window.

Baxter says things were crazy, people weren’t getting enough sleep, and people were misunderstanding each other. So the Fed sent a letter to Lehman on Sept. 15, 2008 to make sure communications were crystal clear. But Holtz-Eakin makes a great point: the Fed doesn’t just go around sending letters to banks saying they still have access to ordinary Fed activities. And Lehman ultimately didn’t end up using the discount window.

After that question Baxter suddenly says communications were always fine. “I don’t think there was confusion.”

The bankruptcy examiner is backing Fuld’s account. The Fed told Lehman it was barring it access from the lending facilities it was offering many other banks. The impression here is that the NY Fed pushed Lehman into bankruptcy and then covered its tracks. Certainly this wouldn’t have been the only cause of Lehman’s failure, but selectively cutting off Lehman’s lifelines while offering the same facilities to Morgan Stanley, Goldman Sachs and Merrill Lynch is pretty bizarre.

There may very well have been good reasons to cut Lehman off. But Baxter isn’t giving any ground. It would be much easier to believe him if everybody at the Fed (particularly the NY Fed) wasn’t stonewalling about every bad decision the Fed made in 2008.



This defense of the Fed’s maneuvering by Thomas Baxter Jr. from the NY Fed is simply not credible. You can act angry and talk about legal restrictions, but we all know AIG happened. Stop waving your hands and explain why you didn’t bail them out when you could have. Dick Fuld was a jerk, the company was garbage, the politics were impossible– whatever you want, just give us something. Nobody believes you, and the constant denials just make you look like fraudsters who liked Goldman and not Lehman.



Fuld says the Fed never told him they lacked authority to lend to Lehman under 13(3).

No sympathy for Fuld, but the Fed’s line that they had the authority to AIG but not Lehman has always been preposterous.



So here’s Lehman Brothers CEO Dick Fuld. He and the bankruptcy attorney handling the Lehman case are the real stars of this afternoon’s session.

So far Fuld is issuing standard denials. False rumors! Slow Fed! Not my fault!

Here’s what to remember. Whatever excuses Fuld puts up, his firm engaged in a classic Enron deception to stay afloat. Their infamous “Repo 105” scam hid billions of dollars in debt by setting up sham transactions to classify that debt as the sale of an asset (cash). Converting debt– money you owe somebody else– into cash on hand is a pretty neat trick. It’s also the basic fraud at the heart of Enron– masking debt as an asset sale.

Whether the Fed was too slow, or rumors deliberately nasty, Lehman was cooking the books.

Fuld also refused to accept a merger in the wee hours before the bankruptcy, believing he’d be bailed out. Paulson called his bluff, and the markets fell apart. None of that gets Fuld off the hook.



That does it for the Wachovia session. No questions about their $380 billion drug money laundering operations, or their ability to get away with it. Bummer.

Otherwise, a lively and interesting hearing.



Wallison is going after Steel on the Bear Stearns rescue, since Steel was directly involved in the negotiations. Basically, Wallison wants to know why it was appropriate for the government to backstop Bear Stearns creditors (and to an extent, their shareholders, who ultimately received $10/share on a failing firm that was worth zero). Wallison’s point is pretty bland– standard moral hazard line that has been trolled out against the Bear rescue for more than two years.

But Steel’s defense is pretty interesting. He said Treasury agreed to the deal because they thought taxpayers wouldn’t actually lose money. Even though they were affirming moral hazard (which whatever Wallison says, existed in the markets before the bailout), Bear shareholders were going to take a big hit, and taxpayers weren’t going to lose a lot of money. Sure, they were subsidizing creditors, but it had to be done, and they got a pretty good deal.

This is interesting because this is not at all what happened when Steel’s bank, Wachovia, was bailed out. And what’s more, the legal avenues for dealing with Wachovia were far more concrete than those for Bear, which involved some pretty creative interpretations of very old laws.

Taxpayers aren’t going to be repaid for what they gave Wachovia’s shareholders. The IRS tax arrangement is not a loan, it’s just a giveaway.



Steel and Alvarez have a lot of gall. These guys completely screwed up as regulators and then Steel made a ton of money off of taxpayers when his bank got bailed out. But guess what? Neither of them want to break up big banks. What do they want? Tougher regulators, nothing more.

Steel: “There are benefits that come from having large institutions, product offerings, economies of scale.”

Alvarez: “It’s going to take regulators with strong backbone going forward.”

Ah, if only we’d had regulators with backbone when Alvarez and Steel were steering the government through the financial crisis!

It’s amazing that people like Steel keep repeating this economies of scale mantra when there is zero evidence, literally zero evidence, that banks the size of Wachovia provide any benefits to the economy that cannot be provided by banks with under $100 billion in assets. He’s just making things up to justify everything he’s done for the past decade, and using economics-talk to make it sound credible. This guy took your tax money and lined his own pockets with it. We shouldn’t take policy advice from people who do that.



The Fed’s Alvarez: “The market didn’t see a failure of Wachovia coming.”

Not credible.

Alvarez wants to say that Wachovia wasn’t really too big to fail, but that the special treatment it received from the Fed and Treasury was warranted. Yes, it rained today, but no, there were not any clouds in the sky.

Douglas Holtz-Eakin asked Alvarez why Wachovia was different from Washington Mutual, which the FDIC shut down without any trouble. Alvarez says that Wachovia was still “well-capitalized.” The trouble, of course, is that if you believed regulators, WaMu was perfectly solvent when the FDIC shut it down, too.

The only reason the market didn’t see a failure of Wachovia coming was because they thought the government would bail it out. Everybody could see that Wachovia was packed to the gills with garbage mortgages. They bought an option-ARM lender at the peak of the mortgage bubble, and then started pumping those loans throughout their entire footprint. They called them “Pick-a-pay” loans for crying out loud!



I need to say a few words about Bob Steel, Wachovia’s CEO at the time the bank went under. Steel joined Wachovia in the summer of 2008, with the financial crisis in full swing, but well before its peak in the Lehman aftermath. When Wachovia picked Steel, he was doing upper-level work at Treasury, and had even been involved in the Bear Steans bailout. I was working in a financial newsroom at the time, and everybody who covered banking was amazed. The revolving door between Wall Street and Washington has been a huge problem for years, but picking Treasury’s bailout negotiator as your CEO in the middle of a financial crisis was a pretty shameless move. Nobody in the newsroom could prove corruption, so it didn’t get much coverage, but everybody knew what was going on.

Steel just told the FCIC that he does not know how much money Wells Fargo saved under the special tax deal the IRS arranged for the merger. That means that Steel is either lying or completely incompetent. He served on the Wells Fargo board after the merger. This was the largest transaction in the history of the bank. He has to know what it cost and where those costs came from. He also said that he had never heard of any discussion about the tax code for bank mergers when he worked at Treasury (IRS is a division of Treasury).

Whether Steel is lying to the Commission– and whether he’s guilty of criminal corruption — is almost immaterial. There’s a very clear perception of corruption in Steel’s move between Treasury and Wachovia. A financial system cannot operate effectively or efficiently under the conditions where some firms are perceived to have special perks that are not available to others. Banks will be able to raise money more cheaply and investors will be willing to take bigger risks when companies are viewed as having a direct line to taxpayers.

There’s been a lot of talk about breaking up the big banks, and it is very important that we do so, whatever the inclinations on Capitol Hill. But it’s equally important to crack down on the revolving door. Officials shouldn’t be able to move from Wall Street to Washington, or the other way around, without a very long waiting period. So long as top officials can shift from Treasury to a bank, or vice-versa, investors will expect bailouts, and the system won’t work.



A rare, interesting line of questioning from Bill Thomas on a little-discussed stealth bailout. In September 2008, under pressure from Henry Paulson, the IRS changed the tax rules on mergers, allowing banks to write-off losses from companies they acquired from their taxes. This made it more appealing for banks to take over other banks, since they could stick taxpayers with the losses, not under TARP, but under the tax code. This turned into a stealth bailout for Wachovia.

The IRS issued its new ruling– which Thomas rightly notes was a complete reversal of the law Congress passed– right after Wachovia inked a merger deal with Citi. Wachovia signed with Citi, the IRS makes it cheaper for banks to take over other banks, and then Wachovia signs a much more generous merger with Wells Fargo. The bailout ends up being conducted through the IRS, rather than a different arm of the Treasury or the Congress or the FDIC.

To the FDIC, the Wells Fargo deal looked good, since it involved no hit to the FDIC’s deposit insurance fund (DIF). Since the FDIC has to deal with failing banks in the “least-cost” manner for that fund, the Wells Fargo arrangement was clearly preferable than the Citi deal, even though it came with much greater moral hazard. But taxpayers still ended up taking a hit, even though the FDIC didn’t pick up the tab. The tax perks Wells Fargo will realize from the ruling will amount to at least $7 billion, money which ultimately passes through to Wachovia’s shareholders. These shareholders invested in a predatory bank that failed, a bank which the government had a proven, safe way to shut down. There is no legal reason for these shareholders to be subsidized by the IRS.

There are only two possible explanations. One, policymakers at the IRS were completely corrupt (Bob Steel worked at Treasury before becoming Wachovia’s CEO in the summer of 2008). Two, Wachovia was too big to fail, and the financial system couldn’t absorb the shocks from hitting its creditors (and even shareholders!) with losses.

If the former is true, people belong in jail. If the latter, then “resolution authorities” cannot end too big to fail. Wachovia proves that even with sufficient legal authority to shut down large firms, policymakers simply cannot do so. That would have grim implications for the new resolution authority Congress just gave regulators to deal with more complex banks when they fail.



Angelides is hammering Alvarez and ex-Wachovia CEO Robert Steel over the accounting at Wachovia. Wachovia bought an exotic mortgage firm called Golden West in late 2006. Golden West’s option-ARM mortgages– some of the riskiest mortgages issued during the bubble– amounted to more than three times the capital that Wachovia held. So why didn’t the Fed or the OCC do something about that well before the bank got in really deep trouble? Why didn’t the Fed say that anything was wrong at Wachovia until July 2008? The mortgage crisis had been going on for more than a year, Bear Stearns had failed, IndyMac had failed. Even if you got caught with your pants down, which the regulators did, you could act once you recognized an overwhelming problem.

Alvarez doesn’t have an answer, because there is no answer. The Fed just looked the other way. So did the OCC, which was run by a former bank lobbyist named John Dugan.

“It was well-capitalized by all definitions,” Alvarez says, claiming that Wachovia faced only a liquidity crunch. That’s a little silly. Wachovia was a commercial bank. It had access not only to deposits, but to all of the Fed’s lending facilities. Provided it’s assets were actually worth something, it could have put them up as collateral for loans from the central bank. Investment banks like Lehman Brothers and Bear Stearns can fail based on liquidity issues– boring commerical banks like Wachovia shouldn’t.



Federal Reserve General Counsel Scott Alvarez is hedging a bit about what the FDIC, Treasury and the Fed did to bail out Wachovia. He keeps emphasizing that no government money was ultimately put up to keep Wachovia afloat, which is true. But the government did invoke a “systemic risk exception” in order to keep the bank open and take bidders for the

There was a war between FDIC Chairman Sheila Bair and then-New York Fed President Timothy Geithner about what to do with Wachovia. Bair wanted to shut the firm down and force its shareholders and creditors to take losses, which the FDIC had already done with dozens of smaller banks. Geithner wanted to bail it out.

Policymakers first orchestrated a merger with Citigroup that would have hit Wachovia’s shareholders hard, but allow creditors to get out without taking losses. A few days later, Wells Fargo stepped in with a much more generous offer, and policymakers approved them, allowing shareholders of a bank that had failed to receive $15 billion.

Alvarez makes an interesting point, however. Policymakers were really worried about the prospect of shutting down a bank that was technically classified as “well-capitalized.” There are three categories describing a bank’s capital levels: well-capitalized, undercapitalized, and critically undercapitalized. Well-capitalized is the strongest category. By definition, a well-capitalized bank should not suddenly become insolvent.

What Alvarez is acknowledging here is that regulators at the Fed and the OCC let Wachovia get away with wildly inaccurate accounting. Instead of taking losses on lousy mortgages, Wachovia was insisting on its balance sheet that those mortgages were really worth a lot of money. It wasn’t true, and the bank ultimately went under, but for months, regulators let the bank inflate its value to stay afloat. It was a prolonged, stealth bailout by the OCC and the Fed.

That’s how a lot of bailouts occur. When things get really, really ugly, the government will offer formal assistance, but if regulators can keep things quiet with funky accounting, they’ll usually do it. This is widely believed to be going on today. The stress tests that Treasury and the Fed conducted in February 2009 blessed the accounting valuations at every major bank in the country, which is why hundreds of billions of dollars in second-lien mortgages are still being held as valuable, even though second liens become totally worthless when home prices decline.



Today’s hearing has the potential to be very interesting. It’s focusing on too-big-to-fail through the lens of Wachovia and Lehman Brothers. Wachovia is particularly important. It was essentially a boring, traditional commercial bank, not a hybrid of commercial banking and complex securities dealing. So unlike other banks that were bailed out, the government always had the legal authority to shut down Wachovia, but chose not to use it. Instead, policymakers orchestrated a merger with Wells Fargo which netted billions for Wachovia’s shareholders.

The company is still getting special treatment today. Too big to fail didn’t end with the financial crisis or the financial reform bill. Wachovia recently reached a settlement with federal prosecutors over allegations that the bank laundered $380 billion in drug money. The bank is getting off with a $160 million fine—a slap on the wrist that will barely register on a the bank’s earnings for even a single quarter—for a crime that would send any ordinary citizen to prison for the rest of his life. No large bank has ever been indicted on federal charges.

The Commission has their work cut out for them today. Should be fun.

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