Inside Perspective on the 2008 Financial Crisis and the Lessons Learned

Introduction

During the financial crisis, I served as Tim Geithner’s chief of staff at the New York Fed and, then when Tim became Secretary of the Treasury, I served as chief of staff for the next president, Bill Dudley. My role allowed me to directly observe an impossibly small number of Americans at the New York Fed, the Board of Governors of the Federal Reserve and the Treasury Department fight desperately to save the financial future of all Americans. Thank you for this opportunity to tell their story.

Bear Stearns

On the night of Thursday, 13 March 2008, I was one of a small group of NY Fed officials huddled in Tim Geithner’s office, listening as several senior SEC officials reported that the investment bank Bear Stearns would not be able to open in the morning. Like a number of investment banks, Bear had become dependent on short-term financing that was largely secured by sub-prime collateral. The providers of short-term financing (money market funds, pension funds, hedge funds, etc.) had grown sceptical of that collateral and Bear had just become the first investment bank whose collateral overnight lenders had lost confidence in. Consequently, Bear had not been able to borrow enough money to make the payments it owed in the morning.

As an investment bank, Bear was part of the ‘shadow banking system’ that was completely outside of the Fed’s jurisdiction and not subject to any kind of ‘prudential supervision’ (i.e. supervision to ensure that it was being run in a safe and sound manner). We had no direct insight into Bear. In fact, some of us did not even know where it was located.

We quickly determined where Bear was located and inserted a team to assess the situation. Their assessment was grim. Bear owed $80 billion to the financial system, had open trading positions with 5,000 counterparties, was a participant in a number of payment systems and, perhaps most worrying, had 750,000 open credit default swap (CDS) contracts.

At this point, Tim and Chairman Bernanke started discussing the possibility of invoking the Fed’s emergency lending authority under Section 13(3) of the Federal Reserve Act to lend to a non-bank. Under Section 13(3), the Fed could lend to a non-bank if it determined that “unusual and exigent circumstances” existed and it was “secured to its satisfaction”.

Fortunately, our examiners determined that Bear had sufficient collateral for us to be “secured to our satisfaction”. Now, the question became whether “unusual and exigent circumstances” existed.

Crisis fighters meeting to discuss the next steps

An important reason why Tim was able to make this judgement was that, concurrent with the failure of Bear, the Fed had utilised its emergency authority to establish a lending facility for the remaining investments banks. As a result, we had first-hand knowledge of their collateral. That in turn meant we already knew that Lehman did not possess adequate. collateral to satisfy the “secured to its satisfaction” requirement of the Fed’s emergency lending authority and that it would not be possible for the Fed, acting alone, to save Lehman.

On Friday, 12 September, we convened leaders from the largest financial institutions. Treasury Secretary Paulson made it clear to the group that they had to find a way to avoid a Lehman failure, most likely by financing any risk that the two potential buyers of Lehman, Barclays and Bank of America, might not be willing to assume. Plan A fell apart when Bank of America decided to acquire Merrill Lynch rather than Lehman and the UK regulators prevented Barclays from acquiring Lehman. There was no plan B. The consortium had already concluded that Lehman’s capital hole was too large for the consortium to have a realistic chance of funding an LTCM-(Long-Term Capital Management) style orderly wind down of Lehman.

The dye was cast. The Fed did not have the legal authority to lend money it knew would not be repaid, there was no buyer for the consortium to support and the consortium knew that Lehman would never be revived regardless of how much rescue breathing the consortium alone applied. Consequently, on the morning of Monday, 15 September, Lehman declared bankruptcy.

Fallout

The markets that Monday were ugly. At one point, the NYSE was down 1,000 points, which was a lot back then. However, stocks rebounded and ultimately closed down 500 points. That was bad, but not a meltdown. Importantly, much of the decline was attributable to rumours that AIG was also in trouble. But we already knew about AIG and it was a much easier case for two reasons.

First, as a trillion-dollar company operating in 140 countries with 30 million customers, a major insurer of 401k plans and a major issuer of CDSs, its potential failure would clearly traumatise the financial system and thereby clearly constituted “unusual and exigent circumstances”. Second, AIG had plenty of collateral for us to lend against. That made AIG a very different case from Lehman and a classic opportunity for a central bank to avoid an unnecessary trauma to the financial system by providing temporary liquidity that was certain to be repaid. For those reasons, on Tuesday, the Fed announced that it was providing an $80 billion credit facility to AIG in return for a 79.9% equity stake in the company.

At that moment, we were cautiously optimistic that a broader panic had been averted. The markets had digested the Lehman bankruptcy and we were on top of the AIG situation. Then the bottom fell out.

On Tuesday, 16 September, word came that a $65 billion money market fund called the Primary Reserve Fund had bought $785 million of Lehman commercial paper, betting that the Fed would bail out Lehman. It bet wrong and that paper became worthless. As a result, the fund was not able to repay $1 for every $1 invested and it “broke the buck”. Investors in the fund did not react well to that. Within 24 hours, they had withdrawn almost two-thirds of their money.

Much worse, investors not only began withdrawing funds from money market funds with exposure to the financial system, they began withdrawing money from ALL money market funds.

Money market funds are among the largest purchasers of commercial paper (CP) and CP is how corporate America funds itself. CP is how Boeing, Caterpillar, Microsoft and General Electric meet payroll and pay suppliers. Suddenly, a crisis that had been limited to the financial system had jumped the tracks into the real economy. Over the next 10 days, lending of all types ground to a halt. Complete panic had set in.

FED Response

This was a terrifying moment. Central banks know how to support individual institutions, but no central bank had ever tried to support entire markets. And that was what we had to find a way to do. It was going to be up to a very small number of Americans sitting in conference rooms at the New York Fed, Board of Governors and Treasury Department to either figure this out, or not. As I looked out from the NY Fed at all the people walking around Wall Street not knowing how close we were to financial collapse, I silently prayed that my colleagues would find a way to avoid a second Great Depression. Then I got sick to my stomach.

Fortunately, my colleagues came through in a big way, starting with an alphabet soup of creative market back-stop facilities with names like the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), the Commercial Paper Funding Facility (CPFF), the Term Asset- Backed Securities Loan Facility (TALF), and others. The mechanics of these facilities varied, but the basic premise was that the Fed, directly or indirectly, would assume enough risk associated with different types of lending that, over time, the confidence of the traditional liquidity providers (money market funds, pension funds, hedge funds, etc.) would be restored and liquidity, the life blood of the financial system, would begin to flow again.

One of the great untold stories of the financial crisis is how much work went into creating and operating these facilities. A remarkably small number of economists, bank supervisors, lawyers and operations personnel spread across several Reserve Banks, the Board of Governors and the Treasury Department worked 24/7 for months to make these facilities successful. As I watched them exhaust themselves day in and day out, I often recalled Churchill’s assertion that “never have so many owed so much to so few”. Fortunately, this was not the Battle of Britain where the liberty of a nation was at stake. But it was a battle where defeat would likely result in a national, if not global, depression. Those were very serious stakes.

The crisis continued well into 2009 with many dangerous twists and turns. But the tiny army of crisis fighters never gave up. The support for AIG was restructured several times. After a rocky start, the Troubled Asset Relief Program (TARP) successfully injected capital into the banks. The FDIC used its systemic risk authority to backstop new unsecured bank debt. The Fed instituted the first-ever stress test to instil confidence in the banks. All of these actions involved tough decisions and a tremendous amount of work.

And they worked. By the fall of 2009, the crisis was over.