William (Bill) Isaac is chairman of LECG Global FINANCIAL Services and served as chairman of the Federal Deposit Insurance Corporation (FDIC) throughout one of its most challenging periods during the savings bank and savings & loan crises of the 1980s.
Isaac’s recently published book “Senseless Panic: How Washington Failed America” details the numerous blunders of government officials during the recent credit crisis that ultimately resulted in the $700 billion Troubled Asset Relief Program (TARP), which Isaac says was completely unnecessary. The book also details steps taken by Isaac during his FDIC tenure that helped stabilize the banking industry during that time of crisis and which should have (but didn’t) serve as a template for dealing with the current crisis.
Shortly after the Lehman bankruptcy, Isaac wrote several op-ed pieces laying out a solution to the crisis, including a four-point plan published in the Washington Post.
Isaac’s recommendations included: reinstating a ban on short sellers, having the FDIC declare an emergency and proclaim all depositors and creditors of banks be protected in case of failure, immediately suspending mark-to-market accounting standards and having the FDIC restore capital in banks.
Following publication of his plan, several members of Congress from both parties urged Isaac to travel to the Capitol to lobby against TARP. He did, and it was defeated in its first attempt before eventually being passed.
Futures: What was your message to the members of Congress you spoke to prior to the TARP vote?
Bill Isaac: The basic message was that the TARP plan would not work. Purchasing $700 billion worth of toxic assets from a $14 trillion financial system just wouldn’t have mattered and it would be unduly expensive to taxpayers because the banks would sell too high and the investors take too little so the taxpayers would get hit coming and going and we would probably lose several billions of dollars if they [had] done the toxic asset purchase plan, which they never did do. After Congress passed this bill (Treasury Secretary) Paulson had second thoughts about it and decided that the toxic asset purchase plan was not going to work so they abandoned it and started doing capital infusions instead including bailing out two auto companies. The basic message I was delivering to them was this plan is not going to work; it is going to be unduly costly for shareholders. Ultimately everyone agreed because they didn’t do it.
FM: Was the capital infusion better than the original plan?
BI: The capital infusion was better but they did not need the legislation to do the capital infusion. The basic message was you don’t need to do this and I gave them a four-step program for what they could do. One was to put more capital in the banks. They ordered the nine largest banks to take capital. Probably only one or two needed it. It set off a whole political firestorm. They also scared the public. It was after the TARP was enacted that the bottom fell out of the stock market and the economy.
FM: Why were they so sure there was no other option?
BI: Paulson, the President, Congressional leaders and the Fed panicked [when they] said that. They kept on saying that hour after hour. Somebody was on the airwaves saying it [would] be financial Armageddon if [it wasn’t passed]. What kind of crisis management is that? They panicked. They let Lehman go down and then they wiped out the $20 billion of bondholders at WaMu on the heels of that and the markets froze up. They said ‘Oh my God what did we do? How do we fix it’? And somebody cooked up this horrible scheme to buy toxic assets. When I say somebody, it sounds awfully like a Wall Street plan. You got to get rid of these troubled assets on our books and Paulson was a creature of Wall Street.
FM: This crisis first broke in the summer of 2007. What should the various regulators have been doing in the summer of 2007 to prepare for this?
BI: They should have been doing a lot of things. They should have been figuring out if Bear Stearns itself was in trouble and how to deal with that. They should have been in there examining Bears Stearns [and asking] how bad is this, is it insolvent or is it just a liquidity problem. If it is just a liquidity problem, how do we solve it? Take Continental IL. We did a joint agreement among the seven largest banks in the FDIC and the Fed. The Fed would loan money to Continental, the FDIC would do a capital infusion in which the seven largest banks would participate. We lined up a public private partnership to shore up Continental and give the markets confidence and that bought us time to come up with some type of a permanent solution. They could have been doing that back in 2007, planning for what happens if Lehman goes, if Bear Stearns goes or Merrill Lynch. I can see how they might not have looked at AIG in 2007, maybe they even had warning signs of that one, but they sure had warning signs on the rest of them. It didn’t take a genius.
FM: There are folks saying what they did saved our financial system.
BI: That is a lie perpetrated by those who dreamed up the idea and sold it to a doubting public and Congress. TARP wasn’t even used for its intended purpose. Everything that was done to resolve this crisis could have been done without TARP, including the capital infusions. They did the four-point plan and the Fed provided a lot of liquidity and those are the things that resolved the crisis together with stopping the failures and making it clear that the largest banks were going to be protected. That became clear when the FDIC negotiated a deal to allow Citigroup to take over Wachovia without any creditors of Wachovia being wiped out. That transaction didn’t occur because Wells Fargo stepped in and bought Wachovia without any assistance but the FDIC reached a hand shake deal to allow Citigroup to acquire Wachovia with substantial FDIC assistance and no haircut to creditors. That was a loud and clear message that this was done, the government is stepping in to protect the system. That is what they waited way too long to do.
They were roundly criticized for bailing out Bear Stearns. Even though they failed, it was viewed as a bailout because the shareholders got something and the creditors of Bear Stearns were protected. There was a lot of criticism. Not from me. I had concerns with how they did it but the fact that they did do it, I thought was essential to keeping some kind of calm and order. There was a lot sensitivity that they could not keep on doing it. There were hawks and doves in the government. The hawks saying ‘impose some discipline and let them fail.’ The doves saying ‘no we have to stabilize the system.’ And neither one could win the day.
I had three issues with [the Bear Stearns deal]. It wasn’t clear to me why they had to fail it at all. Was Bear Stearns just a liquidity problem or was it truly insolvent? If it was just a liquidity problem why didn’t they just keep the Fed credit line in place? It was spectacular when they failed it and dramatic and unsettling, not as unsettling [as it would have been] if they let it [completely] fail. It probably would have caused less of a story if they kept the liquidity line in place. Then they did a privately negotiated deal with JP Morgan (as far as I could see) instead of bringing in other bidders. The other question I have is why didn’t they taken more time, bring in more bidders and get a better deal. Then came Indy Mac and they let it fail. The uninsured depositors and all other creditors took a hit so the hawks won on that one. The next transaction was Fannie Mae and Freddie Mac. The problem with that one was that they told us for three months that it was in fine [shape], no problem it didn’t need government help and then all of a sudden on a weekend they put it in conservatorship but the hawks won again because they wiped out the common and preferred stockholders, which was terribly unsettling to the markets. The preferred stock was held by a lot of foreign governments but it was also held by 2,700 smaller banks and they wiped out those investments that had been rated by the bank agencies at a 20% risk weighting, so they were considered almost riskless investments and they wiped them out and wiped out a lot of smaller banks with it.
Then comes Lehman, and they let it fail. At the time, Paulson’s explanation for that was ‘I would have been run out of town on a rail if I had bailed out something else and I was not going to be know as Mr. Bailout so we let it fail.’ Today, months later, they say [one] they didn’t have a buyer for it which isn’t true –there is a buyer for everything if you make the deal sweet enough; [two], they didn’t have legal authority, which isn’t true and three, Lehman didn’t have enough collateral for the Fed which also isn’t true because the next transaction was AIG and with AIG they were beginning to get really nervous so they bailed it out. They bailed out all of the banks, including Goldman Sachs, which was a big creditor of AIG. They bailed everybody out of AIG and their collateral was the stock. So the Fed ponied up a lot of money there against collateral of questionable value. The next was Washington Mutual. So the doves won on AIG but the hawks won on WaMu because they wiped out the bondholders ($20 billion) and they wiped out the Texas Pacific group that a couple of months earlier had put $7 billion into it.
In the book I call it a schizophrenic failure resolution process. Back and forth, back and forth, and in the end the public didn’t know what to believe anymore. Who is going to fail next? How are they going to handle it? At that point, the government panicked and proposed the TARP legislation and the rest is history. But the TARP legislation didn’t do anything except panic people further because of the highly inflammatory language they used.
FM: Analysts debate moral hazard; it seems that the whole mess is the result of moral hazard. Does this go back to the 1980s and your failed fight to let First Pennsylvania fail?
BI: Yes. It goes back to the Bank of Pennsylvania and a few more. First Pennsylvania is the first pure version of it, nobody paid any price, they just stepped in and put some money into it.
FM: Do banks work too big to fail into their risk measures?
BI: I don’t think the bank bets on that. Even if they don’t fail, a lot of damage is done. Citicorp is trading at $4 a share and it was at $50 or so. The management have a lot of stock options, so management got whacked financially. They try and blame it on excessive greed. Where the moral hazard comes in is the markets let them do it. The shareholders take it on the chin when these things blow up but the creditors believe that these big institutions are too big to fail and therefore they will not take a hit and so these institutions get funded more cheaply than if the creditors felt that they were at risk.
FM: You said that the cost of the Savings & Loan crisis was 10 times what it should have been. Is there a bigger problem looming due to the poor execution of TARP?
BI: Well Freddie and Fannie are the two biggest ongoing things and legislation before Congress does not address that at all. Estimate of losses already are $200 billion and counting. Not to mention the finance companies and the car companies; AIG is not over?
FM: What should they have done with Fannie and Freddie?
BI: They should have done Sen. Corker’s amendment where he tried to impose some bare minimum underwriting standards on the loans, [but] they rejected that in the Senate, which is dumbfounding. That would have been a stop-gap measure but it would have been better than nothing. We have two choices, we break them into smaller pieces and turn them into truly private companies; and the other possibility is to leave them in the government as public utilities with very strong restrictions on them. I don’t know what direction we are going to go. We haven’t had that debate yet.
FM: How should regulators balance the need for transparency with the concerns over setting off a panic?
BI: My view is that the regulator should be forcing banks to disclose every relevant fact about the bank that doesn’t involve a breach of customer confidentiality. I’m the guy who initiated disclosure of enforcement actions. That was not done before I was Chairman of the FDIC. Banks should disclose all of their problem loans. Every fact about a bank that could e relevant to an investor should be disclosed. The thing that the market hates is uncertainty. The markets must feel confident that they have all of the facts. What I don’t think regulators ought to do is have rules in place that are pro cyclical such as loan loss reserving formulas that don’t allow the creation of significant loan reserves in good times or pro cyclical capital rules that don’t require the build up of capital in good times. FDIC insurance premiums that are not paid in good times but are paid in excess in bad times and accounting rules that are pro cyclical. Mark-to-market accounting in particular. We have highly pro cyclical regulatory and accounting systems that make matters worse. It makes the booms more frothy and when we get by in hard times it makes it hard to pull them out.
FM: You stress the need for a counter cyclical regulatory approach. Explain why this is so important.
BI: We have a whole bunch of pro cyclical capital, regulatory and accounting rules. For example, capital standard models look backward in order to determine how much capital you need. If you come through five or 10 years of economic prosperity, which we had leading up to 2007 since the Reagan Administration with few interruptions, you have models that look backwards and [people] say ‘this is an easy business, nobody loses any money, nobody has write offs’ so you don’t need much capital. So capital standards are allowed to slide and that makes the economic boom even more robust because there are no capital restraints on these banks, then when the crisis hits the models start looking backwards and says ‘Geez this bank just lost $20 billion last year. You’ve got to have three times as much capital as you have right now.’ And so they try and force banks to increase their capital during downturns, which only exacerbates the downturns and that is what mark-to-market accounting does. FDIC premiums work the same way, loan loss reserves work the same way so we really need to have counter cyclical accounting rules and regulatory rules in order to stop these wild swings.
FM: Should some form of Glass Steagall be brought back?
BI: I support the Volcker rule. In the end this bill will not accomplish much. I would be tougher. I think that Glass Steagall needs to come back in some form; I think it was a mistake. I am admitting my own mistake because I favored it. The Volcker rule doesn’t allow proprietary trading (for banks) and puts a cap on how big you can be. You can’t have more than 10% of financial assets in the country, which I think is a healthy and important rule. I would take the Volcker rule and add more separation to it. I don’t think we know how to regulate these big firms; the concentration of economic powers is very troubling.
FM: You harshly criticized mark-to-market accounting standards. Some people claim that the only reason things look better today is that these rules were suspended.
BI: Let’s assume that’s true, though it isn’t; Halleluiah. We still don’t have all of the firms failing because of these dopey accounting rules. The FASB really didn’t do much and now they are proposing to expand it. They are putting out a proposal to expand mark- to-market accounting to the entire balance sheet of the banks. That is going to end banking as we know it and make it impossible for smaller businesses and real estate developers and the like to get any sort of long-term credit. I can’t imagine a bank would make loans with maturities beyond a year or so, if they have this mark to market on loans, its insanity that FASB is not learning anything from this crisis.
If Congress doesn’t fix that and put some adult supervision on FASB, they all ought to be run out of office.
There was nothing wrong with these assets except that nobody wanted them because we were in a panic. But the result of writing them off was we lost $500 billion of capital in our financial system by these mark-to-market write offs because of the panic and $500 billion translates to $4 trillion in lending capacity, so why would you want an accounting system that does that when you have a perfectly good alternative. When an asset is in trouble go in and evaluate it and write it down to whatever the projected cash flows indicate. If it shows that the borrower is in trouble and is worth 30¢ on the dollar then write it down to 30¢ on the dollar, but do it based on an analysis not on what some panicky trader is doing in the marketplace.
Meanwhile, the SEC took the short-selling regulations off in 2007 and so the short sellers were working the credit default swaps to drive down the bond prices. Then they attacked the stocks by doing naked short selling. They would go back and attack the bonds again and eventually the stock would get so low that the ratings agencies would be concerned that it would no longer be a going concern and couldn’t raise capital and they would lower their ratings, which caused the funding sources to dry up because the bank couldn’t sell CDs and that’s what fed this crisis, these mark-to-market accounting rules, along with removing restrictions on short sellers. You couldn’t stabilize the system. That is why one of my recommendations was to suspend mark-to-market accounting and another was to put regulation back in place on short sellers.
FM: Often the debate is oversimplified to a battle between tough regulations and free market principles. Do we have to change the debate to being about smart regulation?
BI: It became the mind set of the regulators, particularly the SEC, but also the bank regulators that we need to enlist the markets in the regulation of banks and we need to rely more ostensibly on mathematical modeling and the market and models substituted for regulation and wisdom and experience. Bank regulators put way too much faith in the market’s ability to figure out and regulate these institution and they put way too much faith in the ability of mathematicians to develop predictive models for the behavior of these institutions and their portfolios. What we lost was really experienced people in the regulatory arena and in bank management who would use some judgment about what kind of risk an institution should take, what types of concentrations they should have and how much capital they ought to be applying. Models are helpful but they are an analytical tool and should be used as such, the model shouldn’t be making decisions because nobody understands the models except the mathematicians that created them. The bank management doesn’t understand the models, the bank board sure as hell doesn’t understand the models; you can’t run an institution based on models that you don’t understand. One bad assumption, one bad piece of data can throw those models way off. I bet you there wasn’t a model that said the housing prices could go down, certainly didn’t say they could go down more than 10%. The Treasury and the Fed were very strong advocates of the Basel (Bank for International Settlements) II capital models and the FDIC resisted it and I as a private citizen testified before the Senate Banking Committee on three occasions against the Basel II capital models saying they were pro cyclical backward looking models and there were no absolute standards to them. But the Treasury and the Fed argued that U.S. banks were overcapitalized in relationship to their foreign peers and therefore we needed to go to the Basel II capital standards, so that our big banks could reduce their level of capital to that of their foreign peers, which had about half the capital on a relative basis. If the U.S. averaged 6% capital, the foreign banks were at 3%. I testified before the Senate Banking Committee before the crisis and I said anybody who has been through the 1980s could not possibly conclude that our major U.S. banks were over capitalized. If we wanted to equalize the capital between the U.S. banks and foreign banks, we should force the foreign banks to come up and not reduce the capital in our domestic banks. If you want to do business here, you’ve got to have U.S. style capital ratios. What does Congress do in this legislation? They create a systemic risk council to monitor systemic risk and they turn that systemic risk council over to the Fed and the Treasury, the very agencies that promoted the Basel II capital requirements that any systemic risk regulator worth its salt should have called into question. They put the foxes in charge of the hen coop in this legislation. It is awful what they are doing. They are not working on Basel III because it is agreed throughout the world that Basel II was a flop but God knows what Basel III is going to look like and what bothers me is there is no independent systemic risk regulator to call it into question.
FM: So you are saying the Fed and Treasury had it wrong all along and they are now being put in charge.
BI: They had it wrong on the housing bubble, they had it wrong on Basel II, they had it wrong on the Savings & Loan crisis, the Treasury argued to let the S&Ls grow their way out of the problem. So how can anyone with a straight face create a systemic risk council that is not independent of the agencies? How can you do that? How can you look at yourself in the mirror in the morning if you vote for that?
FM: One of your biggest regrets is losing the battle over brokered deposits by money brokers (who were gaming the $100,000 limit on insured deposits). Does that still present a risk?
BI: It cost taxpayers tens of billions of dollars in the S&L crisis. It is still a problem. What happens is that Congress passed a law saying that the FDIC had the authority to limit the use of brokered deposits by problem banks — big deal. The horse is gone and let’s close the barn door after the fact. It actually creates a bigger problem. If a bank seems healthy and loads up on brokered deposits and grows due to a lot of bad loans and then the FDIC comes in when it detects a problem and says you can’t use brokered deposits anymore; now the bank has a first-rate liquidity crisis, which causes it to fail when it might have been saved. Why do we let them have all those brokered deposits in the first place?
FM: Some people are concerned with what seems to be Goldman Sachs’ permanent seat at the table. Are the large Wall Street firms even more entrenched than ever before?
BI: You saw in the book the phone log (Isaac detailed how at the time of the crisis in September 2008 New York Fed president and future Treasury Secretary Geithner had significantly more correspondence with Wall Street firms, particularly Goldman Sachs, and Treasury Secretary Paulson than his boss at the Fed). It speaks for itself, it speaks volumes. There is a very tight relationship between the major financial institutions and the government whether it is the legislative branch or the administration. There is a very tight relationship and there are major amounts of contributions. Right now, the administration and the congressional leaders talk a good game, they say ‘we are [going] to get those big bad Wall Street firms in their proper place’ but look at what they do not what they say, and this bill doesn’t do much.
FM: How should securitization be changed?
BI: The idea that people had was to require that there be some significant skin in the game [but] I don’t hear that much more and my sense is that that fell by the wayside and not much is changing. The rating agencies are still doing their thing. I don’t know how to change it unless you change the rating agency model entirely so that there are all these conflicts in how they are compensated. The other possibility is to require the firms that originate these securitizations to retain a significant interest in them, so there is a reason for them to care about the quality of what they are selling to everybody.
Bank examiners already make determinations about much more difficult to judge assets (i.e., loans), so they ought to be in a position to make judgments about marketable securities. They don’t get paid by the institutions; the institutions assess fees that are mandatory. You don’t get a choice; you don’t get to shop for your agency. If the bank examiner is doing it, there is no shopping for the rating. It looks like what this amendment does is make rating agencies irrelevant.
Somebody has to determine whether these are quality investments and it looks like it is going to be the bank examiner not the ratings agencies which is probably an improvement.
FM: It seems like the SEC keeps getting more authority after their failures, do you see this continuing?
BI: I don’t understand how the SEC, which is one of the primary culprits in this crisis, gets left off the hook. The SEC clearly needs to be reformed as an agency. It needs a new mission statement; it needs a real shakeup. It is a lawyer-dominated agency, so they need a different makeup of personnel and they need a new mission. They think as long as you disclose it, it is ok, they need to be more of a regulator. It used to be a proud agency that had quite the track record but they have lost their way.
FM: You have noted that many of these decisions have become politicized. How do we get away from that?
BI: I have never seen the bank regulatory climate or the crisis management process nearly as politicized as it is right now. The Treasury is a political agency, it is not an independent agency and it is the big winner in this. It has almost all the power. For decades, the Fed and Treasury have been locked in battle with the Fed fighting for its independence, so the Treasury doesn’t dominate it. It looks to me like that battle has largely been lost by the Fed and the Treasury has become the dominant agency and I do not think that is healthy for our economic system or our financial system and it makes us unique in the world.
I can’t think of another country where the Treasury is so dominant if these things become law. Even without these becoming law, the Treasury in this last crisis clearly was dominant and they made a mess of it.
FM: Congress is busy reconciling the two bills. What should be taken out of it and what needs to be put in the legislation?
BI: Probably the most serious problem is the Collins amendment. I am much more concerned with what is not in the bill, what the bill doesn’t do. The bill does not provide any oversight over FASB, which is desperately needed, the bill does not address the serious problems at the SEC, and the Bill does not create a systemic risk council that is independent. It turns it over to the Treasury and the Fed and other agencies that it is supposed to be overseeing. The bill does not enhance, in any way, a broken and badly politicized regulatory system and the bill does not do anything to address the Fannie and Freddie problems. Those are major deficiencies; I don’t know how you can call it a reform bill if it does address those things.
The Collins amendment says that Trusts preferred stock is no longer counter as tier one capital and while I have no problem with the direction that is heading, I think that is good, you can’t do it now, it is effective immediately and would destroy $130 billion in tier one capital. That is a lot of lending capacity they are killing. If you want to go there, then phase that in. You can’t lay that on the system immediately.
They also have to restore the crisis management powers. This is something in the bill that I find highly objectionable. If this becomes law they really have tied the hands of the FED and the FDIC to handle a crisis or a problem short of a crisis, to head it off by stepping in and intervening. The really gutted the authority of the Fed to lend and the FDIC to backstop institutions that are important and try and bring a situation into control before it creates a crisis. That is very unwise. If the Fed and FDIC’s hands are tied then in the next crisis, it will get out of control for sure because they won’t be able to do anything to stop it. Then we would be back to asking the taxpayers for a lot of money or nationalizing the system. They also need to address the concentration in the system. Our five largest banks control over 50% of the financial assets and banking asserts. That is just unhealthy to have that much concentration.
FM: Break them up?
BI: Some say break them up but I have another idea on how to address it. This idea came along late in the process but they are in such a hurry to get something passed before the election. I think [it] is a terrible idea to rush this in before the election because [everyone] is under such political pressure because they are all embarrassed by their TARP votes. They are trying to bang on the Wall Street banks and make them pay for the error of their ways. Lets have a reasonable debate and lets do reform after the election.