Yesterday, the Financial Crisis Inquiry Commission (FCIC) held the first of a two-day hearing entitled “Too Big to Fail: Expectations and Impact of Extraordinary Government Intervention and the role of Systemic Risk in the Financial Crisis.” The focus of the first day was the government’s roles with respect to the sale of Wachovia Corporation and the failure of Lehman Brothers. Testifying before the FCIC were the following witnesses:
Session 1: Wachovia Corporation
- Scott G. Alvarez, General Counsel, Board of Governors of the Federal Reserve System
- John H. Corston, Acting Deputy Director, Division of Supervision and Consumer Protection, Federal Deposit Insurance Corporation (FDIC)
- Robert K. Steel, former President and Chief Executive Officer, Wachovia Corporation
Session 2: Lehman Brothers
- Thomas C. Baxter, Jr., General Counsel and Executive Vice President, Federal Reserve Bank of New York
- Richard S. Fuld, Jr., former Chairman and Chief Executive Officer, Lehman Brothers
- Harvey R. Miller, Business Finance and Restructuring Partner, Weil, Gotshal & Manges, LLP
- Barry L. Zubrow, Chief Risk Officer, JPMorgan Chase & Co.
FCIC Chairman Phil Angelides opened the hearing by explaining the FCIC’s interest in looking through the lenses of Wachovia and Lehman to examine the evidence of potential system-wide risk from institutions that became the focus of the government’s unprecedented intervention in the U.S. financial system three years ago. He first noted that for the past three decades bank bailouts have happened with increasing frequency and have created growing burdens on taxpayers with no real steps to reverse the trend. “To my mind, we have been living in a kind of “Financial Groundhog Day” he said. “We vow to wake up and change course, and then we repeat what we’ve done before.” Further observing that the American public has questioned whether the government chose the right course in moving to “toss flotation devices” to certain institutions while most of the economy “took on water”, Mr. Angelides centered discussion on a single issue, stating, “The real question before us is: How did we end up with only two choices – either bail out the banks, or watch our world sink?”
The discussion opened with questions concerning the witnesses’ awareness and evaluation of systemic risk leading into the crisis. The Commissioners asserted that, prior to September 2008, government regulators took no action to manage risks confronting too-big-to-fail institutions and made no comments or recommendations concerning the financial system at large. The Commissioners described Wachovia’s rapid growth from $254 billion in asserts in 2000 to $787 billion in 2007 and corresponding increases in total leverage, with little expression of regulatory concern. The Commissioners maintained that Wachovia was clearly in trouble and posed a risk to the system at large while regulators remained silent and inactive.
The witnesses defended their performance, first citing statutory limitations that hampered their evaluation of systemic risk. Mr. Alvarez noted that prior to the passage of the Dodd–Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), federal regulators were largely limited to the review of national banks for financial soundness and were denied the means or authority to evaluate system-wide threats those institutions posed. Witnesses agreed that Dodd-Frank fixes the “holes” in the regulatory system in a number of ways, most notably through the creation of the Financial Stability Oversight Council, which is required to identify those entities and activities across the system that should be subject to heightened prudential standards and has the authority to enforce stricter regulations.
Commissioners were clearly dissatisfied with this response, arguing that the pattern of aggressive growth and high leverage concentrated in risky assets was easily recognizable in Wachovia and demanded such action as regulators were able to take. Said Mr. Angelides, “It’s the old biblical reference, 7 years of feast and seven years of famine. You needed to prepare. You had the authority to require higher capital ratios and build a bulwark.”
The witnesses responded that conditions did not warrant capital adjustments in Wachovia’s case. Each agreed that Wachovia was well capitalized and that its growth and size, considered independently, were not negative features that would raise concern. Said Mr. Steel, “There are benefits that come from having large institutions, product offerings, economies of scale.” Mr. Corston did admit concerns over the Golden West acquisition, centering on the uncertainty of the integration of a monoline risk institution into a diverse enterprise such as Wachovia. Indeed, he contended that his discussions with the OCC in part led to its downgrade of Wachovia in August 2008. Yet, Mr. Corston admitted that he still lacked “appreciation for the sensitivities to the funding market” posed as a result of “statutory gaps” preventing the exercise of macro-prudential review.
Turning the discussion to the government’s actions in the wake of Wachovia’s failure, the Commissioners questioned the decision to decline seizure, particularly in light of the previous week’s seizure of Washington Mutual. Mr. Corston argued that Washington Mutual’s failure was easier to manage because the FDIC had “adequate time to develop strategies and understand the risks associated with those strategies.”
By contrast, the FDIC was not informed of Wachovia’s condition until the weekend of its collapse, leaving the FDIC with insufficient time to develop and execute a resolution strategy. According to the witnesses, the prospect of Wachovia suddenly ceasing operations was too dire given its large counterparty exposure to many other financial institutions and its role in providing back-up liquidity support to many other traded instruments. These same factors made government seizure undesirable because of the potential shocks to business and consumer confidence. In the end, the Federal Reserve, the FDIC and then Treasury Secretary Henry Paulson unanimously agreed that government acquiescence to the Wells Fargo acquisition was the correct course of action taken under extremely difficult circumstances. Looking forward to the exercise of powers under the Dodd-Frank regime, Mr. Alvarez affirmed that similar strong-minded execution will be needed to realize the benefits the new law contemplates.
FCIC Vice-Chairman Bill Thomas noted that on September 30, 2008 the Internal Revenue Service issued Notice 2008-83, which changed the tax rules on mergers by allowing banks to write off losses from companies they acquired. Mr. Alvarez confirmed that on October 2, 2008 Wells Fargo contacted the FDIC with an offer after determining that “certain U.S. federal income tax benefits resulting form the proposed Wachovia transaction would allow it to acquire Wachovia without FDIC assistance.” Calling Notice 2008-83 a “rifle shot” that created a “backdoor way” for the government to aid banks through the IRS while allowing the Federal Reserve and the FDIC to enjoy zero loss exposure and crippling shocks to consumer confidence, Mr. Thomas questioned whether all resolution regimes will ultimately be subject to the psychological and economic realties that support the too-big-to fail concept.
Working from the assumption that systemically critical institutions will remain a reality in the U.S. economy, the Commissioners opened discussion in the second session by questioning whether Lehman Brothers should have been considered too-big-to fail when it was allowed to file for bankruptcy. Mr. Zubrow argued that Lehman Brothers was an important counterparty to many institutions in the market place and thus was “an important systemic entity.”
Echoing opinions expressed in the first session by Mr. Alvarez, Mr. Baxter argued that the question of whether Lehman Brothers should have been a target of federal aid was legal rather than philosophical in nature. The Federal Reserve under existing law could only lend to institutions it judged to be “secure”. For Mr. Baxter, weak capitalization and insufficient collateral made direct government aid inconceivable.
Mr. Fuld disagreed, saying that “there was no capital hole” at Lehman Brothers and that it had $28.4 billion in equity capital two weeks before filing for bankruptcy protection. He also contended that Lehman Brothers had adequate collateral, and that all it needed was access to the same capital facilities given to each of its competitors to survive the run that led to its demise. Despite concerns from the Commissioners that regulators made “a conscious policy decision” not to rescue Lehman Brothers, Mr. Baxter maintained that the Federal Reserve and Treasury tried in earnest to save the company. Yet, without a prospective buyer, inadequate capital to ensure viability in the face of “insufficient investor appetite” and not enough collateral to assure repayment of taxpayer funds, regulators were without the needed conditions to carry out a rescue.
Witnesses from both sessions agreed that under the new regime regulators will have to enforce front-end measures to require better assessment and management of risk. Moreover, efficient resolution will have to replace government aid should systemically important instructions falter. Determining which institutions will be so designated and determining the mechanisms employed will continue to be a complex process involving a host of considerations within the contingencies of the broader market.
The FCIC will wrap up its Washington and New York hearings today before conducting a series of four field hearings throughout the month of September in advanced of its mandated December 15, 2010 report to the President containing its findings and conclusions as to the causes of the financial crisis.