14

All Together Now: The Fed and the Treasury Join Hands

Necessity is the mother of invention.

—WELL-KNOWN PROVERB

By the fall of 2008 the Bush administration was pretty much a spent force, beaten down mainly by the endless wars in Iraq and Afghanistan. The president’s job approval rating in a Gallup poll stood at 31 percent just prior to Lehman Day and then dropped to an all-time low of 25 percent at the beginning of October 2008. The president himself seemed disengaged, delegating economic management almost completely to Secretary of the Treasury Hank Paulson. And, of course, a presidential election loomed on the near horizon, pitting the dynamic young Senator Barack Obama (D-IL) against the much older war hero Senator John McCain (R-AZ). It was not a propitious moment for activist fiscal policy—with one big and highly unusual exception: the Troubled Assets Relief Program (TARP).

Unfurling the TARP

The TARP was invented on the fly. As Paulson later put it, “frankly we had no choice but to fly by the seat of our pants, making it up as we went along” (Paulson 2010, 254). The impetus came after Lehman Brothers failed and then, just days later, American International Group (AIG) was nationalized in deed though not in word. The panic was on. Paulson, a former king of Wall Street, saw things spinning out of control so badly that “we couldn’t keep using duct tape and bailing wire to try to hold the system together” (254). Chair Ben Bernanke at the Fed strongly joined in that judgment, telling Paulson “we can’t keep doing this” (Sorkin 2010, 431). Bernanke was also eager for Congress to get the central bank off the hook by appropriating money for financial rescue missions.

Paulson and Bernanke had many motives in proposing what eventually became the TARP. First and foremost, the financial conflagration was spreading, not receding. Increasingly it looked like “the big one,” the time to pull out all the stops. Second, despite (or perhaps because of) using the Exchange Stabilization Fund to stabilize the money market mutual funds after Lehman crashed, Paulson felt an acute need for a pot of money explicitly appropriated by Congress for financial firefighting.1 Who knew what might come next? Third, the Fed had stuck its neck way out to save both Bear Stearns and AIG and in other ways too. With each ad hoc emergency rescue program, public money was being put at risk by the nonpolitical, unelected Federal Reserve System. Bernanke was highly uneasy about this development for reasons of democratic legitimacy. Such decisions, he believed, should be made by elected politicians. Finally, all the ad hockery had left financial markets confused about the rulebook. Was there one?

As the two financial leaders and their staffs planned for the TARP, a major difference of opinion emerged between the former economics professor and the former Wall Street mogul. The intellectual Federal Reserve chair, backed by the New York Fed, favored injecting capital directly into banks to bolster their weakened balance sheets. An expert on economic history, Bernanke knew that publicly provided capital almost inevitably follows in the wake of a banking crisis—sometimes sooner, sometimes later. Why wait for things to get worse? Besides, providing banks with new capital would leverage the government’s money. Since banks typically operate with approximately ten-to-one leverage, each $1 of additional bank capital should support $10 or so of renewed lending, at least in theory.2

But the less cerebral, more action-oriented treasury secretary overruled Bernanke on both political and market grounds. Politically, any proposal to purchase bank shares, thus making the government a part owner of the country’s largest banks, would be decried as socialism by Republicans and vilified as gifts to fat-cat bankers by Democrats. It wouldn’t stand a chance in Congress. Furthermore, even a partial nationalization of the banks would scare off private investors, whom the Treasury and the Fed were still hoping to coax into buying equity in banks. (Bank stock prices were very depressed.) For these quite legitimate reasons, Paulson didn’t want to inject capital directly into banks; he didn’t even want to let anybody talk about it, lest the idea of purchasing bank shares leak into the public discourse.

When it comes to political matters and especially in dealing with Congress, the chair of the Federal Reserve generally defers to the secretary of the treasury, who after all represents the president and therefore carries implied political legitimacy. Besides, Paulson’s read of the political environment was probably pretty good. So, when the pair trooped down to Capitol Hill to implore Congress to help, their plea was to fund Paulson’s pet idea (buying toxic assets), not Bernanke’s (injecting capital into banks).

The political drama began in earnest at a remarkable meeting on Thursday night, September 18, 2008, just three days after the Lehman bankruptcy. The Fed chair and the treasury secretary, having first conferred with President George W. Bush, sat down with congressional leaders of both parties, who had been hurriedly convened in the conference room of the Speaker of the House, Nancy Pelosi (D-CA). As they filed in, the pictures in the minds of members of Congress were nowhere near as bleak as those of Bernanke and Paulson. Members still saw the unfolding disaster as a Wall Street problem, not a Main Street problem. They were also viscerally hostile to bank bailouts. Both the Bear Stearns rescue and the AIG bailout had been extremely unpopular with their constituents. Senators and Members of the House were wary, to put it mildly, of putting massive amounts of taxpayer money at risk to salve banks’ self-inflicted wounds. In their minds, this was akin to political suicide.

In stark contrast, using the Federal Reserve’s ample balance sheet looked pretty attractive to those few politicians who understood the Fed’s capabilities. Via the Fed, money could flow to banks in their districts without Congress appropriating a dime, Bernanke would take the heat if anything went wrong, and members of Congress could later berate the Fed for overstepping its authority or for anything else they didn’t like. This last point—the Fed’s acute political exposure—was, of course, exactly what Bernanke was trying to minimize.

By all accounts—and members of Congress do talk, so there were plenty of eyewitness accounts—the September 18 meeting was extremely tense. Paulson was seen by the Democrats as pleading to bail out the moneyed interests. As he had confided to Bernanke earlier, “They’ll kill me up there. I’ll be hung out to dry” (Wessel 2009, 203). In fact, before the treasury secretary left for Capitol Hill that evening, his chief of staff had warned him that “this is only going to work if you scare the shit out of them” (Sorkin 2010, 445). Though crudely put, it was probably sound advice. And Paulson took it.

Paulson and Bernanke apparently went well beyond merely outlining their vision of the financial Armageddon in store for the country if Congress didn’t act with dispatch. According to some members of Congress present at the meeting, the two went much further and actually sketched a scenario in which civil order broke down and there was rioting in the streets. Apparently, there was much gulping around the big mahogany table. As Paulson later wrote, Bernanke’s devastating assessment of what might happen to the economy “was enough … to leave the members of Congress ashen-faced” (Paulson 2010, 259). Bernanke himself later said, “I kind of scared them. I kind of scared myself” (Wessel 2009, 204).

In the less polemical moments of the meeting, one presumes, Paulson outlined the plan he wanted to introduce the next morning. The Treasury would buy troubled assets from the banks, thereby both raising the assets’ market values and getting them off the books of troubled banks. The Treasury purchases would make banks healthier, thereby helping the economy avoid the worst. Unfortunately, doing that would require hundreds of billions of dollars, and Treasury wanted the legislation passed within days. Appropriating that kind of money that fast shocked the assembled legislators, who were accustomed to acting at a far more leisurely pace, especially in the Senate where, as Majority Leader Harry Reid (D-NV) quipped, “It takes me 48 hours to get Republicans to agree to flush the toilets” (Hulse and Herszenhorn 2008).

But the congressional leadership, stunned by the apocalyptic vision, reluctantly agreed. It was a rare moment of bipartisanship. The mere news that the meeting had taken place ignited a strong stock market rally the next morning. But Reid, McConnell, Pelosi, and most of all House minority leader John Boehner (R-OH) would soon learn that their members were by no means ready to stretch a protective TARP over the financial system.

The next morning, Paulson outlined his plan at a press briefing, defending the basic idea—“These illiquid assets are choking off the flow of credit that is so vitally important to our economy”—and declaring himself “convinced that this bold approach will cost American families far less than the alternative” (Paulson 2009), which was presumably a mammoth financial collapse of 1930s dimensions or worse. He did not, however, put a price tag on the TARP. That was no accident, for the Treasury had not yet decided how much money to seek. Paulson and some top aides wrestled with that question that very night. Here is journalist Andrew Ross Sorkin’s version of how the conversation went:

“What about $1 trillion,” [Neel] Kashkari said.

“We’ll get killed,” Paulson said grimly.

“No way,” [Kevin] Fromer said, incredulous at the sum. “Not going to happen. Impossible.”

“Okay,” Kashkari said. “How about $700 billion?”

… As he plucked numbers from thin air, even Kashkari laughed at the absurdity of it all. (Sorkin 2010, 450)

But who could blame them? No one knew how much would be enough. (As it turned out, $700 billion was more than was needed.)

Congressional passage proved difficult. Paulson originally submitted a three-page draft giving him virtually unlimited power, even precluding judicial review. This short and explosive document was greeted with a combination of derision and alarm, and Democrats in Congress—who held majorities in both Houses at the time—began working with the administration on their own version. Numerous changes were made along the way. Judicial review was, of course, restored. The TARP money was appropriated in tranches rather than all at once, thereby saving some for the next administration. Multiple layers of oversight were added including a Congressional Oversight Panel, which wound up being headed by a Harvard Law School professor named Elizabeth Warren. Warren proved to be both a zealous guardian of the public purse and a thorn in the side of first Secretary Paulson and then Secretary Tim Geithner. Her high profile later propelled her to the U.S. Senate and even to a run for the White House in 2020.

Perhaps most important, clear language directing the Treasury to use some of the TARP money to mitigate foreclosures was added in several places throughout the bill, including in the basic definition of what constituted a “troubled asset.” Paulson had requested no such language. But there was no mistaking the intent of Congress. Members wanted some of the bailout money—maybe a lot—to go to distressed homeowners, not just to distressed banks.

The bill that ultimately passed, the Emergency Economic Stabilization Act of 2008, ran to 451 pages, of which 261 dealt with the TARP. But nowhere in those 261 pages can you find a single word about using TARP money to inject capital into banks, Bernanke’s pet idea but one that Paulson failed to mention. There was, however, a catchall phrase under which the secretary of the treasury was authorized, after “consultation” with the chair of the Fed3 and a written explanation to Congress, to purchase “any other financial instrument that the Secretary … determines the purchase of which is necessary to promote financial market stability.” Language that broad allowed pretty much anything.

The House leadership believed they had the votes to pass the TARP bill on September 29, but the rank-and-file surprised them by rejecting it on a 205–228 vote. Opposition came from both Republicans and Democrats, though for starkly different reasons. The Right posed the bigger problem; more than two-thirds of House Republicans voted against the TARP. Apparently, Bernanke and Paulson hadn’t quite “scared the shit out of them.” But the stock market soon did. The S&P 500 fell almost 9 percent the next day, destroying about $1.25 trillion of wealth—almost twice the TARP request—in a single day. That sell-off made believers out of enough House members to pass the bill by a comfortable 263–171 margin four days later. The Senate had already passed it, and President Bush signed the legislation into law on October 3, 2008.

It was noteworthy that Chair Bernanke more or less disappeared from view as the political debate proceeded. Appropriating money, he properly believed, was a fiscal policy issue. The distinction was critical to him (and to others). The inability or unwillingness of the Treasury to take the lead prior to TARP had forced the normally reclusive Federal Reserve to step into the spotlight repeatedly. Although its emergency lending was clearly legal under authority granted by Section 13(3) of the Federal Reserve Act, a number of the central bank’s actions had put taxpayer money at risk. And putting money at risk is just a step away from spending money, a power reserved to Congress. Furthermore, the Fed had been pushed into both the political arena and the media spotlight and was eager to get out of both. As Don Kohn, a Fed careerist who was then the Fed’s vice chair, put it with some relief, “As the Treasury stands up, the Fed stands down” (Wessel 2009, 205).

While this political drama was playing out in Congress, something else that would damage the TARP’s image was brewing behind the scenes. Paulson became persuaded that Bernanke had been right all along: injecting capital into banks was a better salve for the financial system’s wounds than purchasing troubled assets. Treasury staff work had apparently convinced Paulson that designing a program to purchase toxic assets was fraught with difficulties and would take too long.4 Buying equity stakes in banks would be simpler and faster. When the treasury secretary informed his top press officer, Michelle Davis, of his decision, she reacted with stunned disbelief. “We haven’t even gotten the bill through Congress. How are we going to explain this? We can’t say that now” (Wessel 2009, 227). And Paulson didn’t.

In consequence, the U.S. Senate and House of Representatives voted to inject capital into banks while thinking they were voting to purchase troubled assets and mitigate foreclosures. The TARP, which certainly did not need any more political baggage, got some anyway when Paulson announced his radical change of plans just nine days after Congress passed the new law. It looked like a classic case of bait and switch. Ironically, later in the crisis the Fed would step in to do something very close to what the TARP was originally designed to do,5 with the Treasury kicking in money to shield the Fed from any possible losses (more on the Fed’s actions below).

Paulson was a man of action. As soon as he made the October 12 announcement, he was on the phone with the CEOs of America’s nine largest banks telling them that he and Fed Chair Bernanke were inviting them to a meeting at the Treasury the next day. It was a euphemism. When the secretary of the treasury and the Fed chair “invite” you to an emergency meeting, you don’t check your calendar; you pack your bags. And they all did, not knowing what to expect. As it turned out, they were going to be force-fed the initial installments of the brand-new Capital Purchase Program (CPP), Treasury’s name for the capital injections from the repurposed TARP.

Technically, the government lacked the legal authority to compel banks to participate, but Paulson made it clear that their answers would all be yes (Wessel 2009, 238). “If you don’t take it and you aren’t able to raise the capital … in the market,” he said, “then I’m going to give you a second helping [of capital] and you’re not going to like the terms” (Sorkin 2010, 527). Banks that were teetering on the brink of survival (such as Citicorp) or were politically astute (such as Goldman Sachs) accepted with alacrity. After all, the Treasury had designed the terms to be attractive, not onerous.6 But a few well-capitalized banks didn’t welcome the partial nationalization and feared interference from Washington. The most vocal of these was Wells Fargo, which had already announced plans to raise $25 billion privately. Paulson’s response to Wells Fargo’s plea was unequivocal: “Your regulator is sitting right here. And you’re going to get a call tomorrow telling you you’re undercapitalized” (Sorkin 2010, 528). So much for voluntary acceptance. All nine bankers signed on the dotted line. Incidentally, the CPP included no commitments to mitigate foreclosures, none at all.

Paulson made the terms banker-friendly in order to get the big banks to sign up willingly. But his extreme generosity toward banks coupled with the stinginess toward homeowners was politically tone deaf; it fed the claim that this was a “bank bailout.” Yes, the Treasury got the broad and rapid take-up it wanted, but the CPP’s design had two sets of adverse consequences, one political and the other economic. Politically, because bankers were villains in the eyes of the public, the program’s munificence made the CPP and therefore the entire TARP extremely unpopular. It was viewed as a giveaway to undeserving bankers while millions of homeowners struggled to avoid foreclosure. Economically, forcing capital on banks that didn’t want or need it wasted a precious share of the $700 billion that Congress had appropriated. What if more funds were needed, perhaps for more rescues or for mitigating foreclosures or even for buying troubled assets?

The Election of 2008

While all this was happening on the financial front, the United States of America was in the home stretch of a historic presidential election pitting the preternaturally calm man who would become America’s first black president against a mercurial war hero who would have been (at the time) the oldest president ever elected for a first term. In the days leading up to the Lehman Brothers bankruptcy, John McCain had pulled ahead of Barack Obama in a Gallup poll by about 4–5 points. But right after Lehman the lead flipped, with Obama surging ahead by roughly 4 points (figure 14.1). And Obama never looked back. Amid the turmoil, the voters preferred calm to mercurial.

On September 25 while TARP legislation was being debated, a somewhat panicky-looking McCain suspended his campaign, suggested calling off the upcoming president debate (which Obama refused to do), and dashed back to Washington for a crisis meeting at the White House, a meeting that he, not President Bush, called. I suppose the former naval officer hoped the operation would look like “John McCain to the Rescue.” According to most participants, however, it turned out to be a waste of precious time—or worse.

McCain’s performance put the spotlight on his reputation for being hasty and erratic at times, which was not what the electorate was looking for during the Panic of 2008. Calm, smart, and thoughtful were more like it. Immediately after the September 25 fiasco, Obama’s Gallup poll lead widened to 8 points (see figure 14.1). No one knew it at the time, but for all intents and purposes the race was over. One Obama campaign aide later told journalist Noam Scheiber that “I believe we won the election in the ten days between the collapse of Lehman and the first debate. It created the sense that one guy was solid and had his feet on the ground, and the other guy was not” (Scheiber 2012, 15). Obama won the popular vote on November 4 by a convincing 7.2 percentage points and the electoral vote by a smashing 365–173 margin.

FIGURE 14.1. Obama-McCain opinion polling: Calm beats stormy.

Source: The Gallup Organization.

American law provides for a long transition between administrations. In this case, it was a long and agonizing transition. President George W. Bush appeared to have checked out. So, on any given day many Americans didn’t quite know whether they had one president, two presidents, or none at all at the helm. Paulson also looked like a spent force, though he slogged through another two and a half months before President Obama replaced him as treasury secretary with Tim Geithner, who came over from fighting the crisis as president of the New York Fed. Geithner took charge of the remaining $350 billion in available TARP money late in January 2009, though he never deployed anywhere near the full $700 billion (U.S. Department of the Treasury 2021).

In the end, the TARP proved to be among the most successful but least understood economic policy innovations in our nation’s history. For years, it had a terrible name with the body politic. For example, a Pew poll in February 2012 found that just 39 percent of Americans thought TARP’s “major loans to banks and financial institutions to try to keep the markets secure” in 2008 were “the right thing … for the government to do,” while 52 percent thought it was the wrong thing. The poll then quizzed Americans on “how much of the … money … has been paid back.” Only 15 percent gave the correct answer at the time, which was either “all of it” or “most of it.” By contrast, 72 percent chose either “only some of it” or “none of it” (Pew Research Center 2012). For years after TARP’s passage, one of the surest ways to kill any proposal being considered by Congress was to brand it as being like TARP.

The Federal Reserve Gets Inventive

Monetary policy was busy during this period, too. The conventional part was simple and uncontroversial: the Federal Open Market Committee (FOMC) lowered the federal funds rate to the floor. As mentioned earlier, the committee had ceased cutting the funds rate at 2 percent in April 2008, when they paused to see what would happen next. On October 8, the committee resumed rate cutting and with a renewed sense of urgency. As the FOMC approached its December 16, 2008, meeting, the funds rate was down to 1 percent and virtually certain to be reduced further. But not even close Fed watchers anticipated what a landmark meeting was about to occur.

During the three months that had elapsed since Lehman Day, a frail U.S. economy had descended into disaster, and the Fed had taken numerous drastic actions, many of which the central bank’s hawks didn’t like. Prior to the December 16 meeting, market speculation was rampant about what more the Fed should, could, or would do. There were three main candidates.

The first was to apply more conventional expansionary monetary policy. While the federal funds rate was already down to a superlow 1 percent, the FOMC could reduce it further. The markets judged a cut of 50 basis points most likely. Second, the committee could try to reduce longer-term interest rates by committing to holding its overnight rate low for a long time. Some called that “open-mouth policy”: talking the yield curve down. Nowadays we call it “forward guidance,” and we expect it routinely from the Fed. Back then, however, it was a nearly revolutionary idea. Third, the FOMC could keep expanding its balance sheet, which had already soared from $924 billion the week before Lehman to $2,262 billion on December 11. (What would later be called QE1 had started in November.) Which option would the Fed choose?

In a stunning outcome that made it clear there were no hawks left on the FOMC, the answer turned out to be “all of the above.” In the committee’s own language, it decided to use “all available tools” to fight the recession. All available tools? Actually, the Bernanke Fed was inventing tools as it went along. For openers, the federal funds rate was slashed from 1 percent to a range between zero and 25 basis points. That marked the biggest rate cut in twenty-six years and was more than the markets expected. Over the next year the effective federal funds rate would average 16 basis points, dipping as low as 8–9 basis points at times.

As it turned out, the FOMC wound up maintaining that range of 0–25 basis points for seven long years. But it steadfastly refused to go all the way to zero, much less into negative territory—even years later, when many other central banks around the world had pushed their overnight rates below zero. Why not?

I was a prominent advocate of a negative federal funds rate during those years, urging several FOMC policy makers, including Chair Bernanke, to “go negative.”7 The Fed’s counterarguments, which seemed to emanate mainly from the New York bank, looked flimsy to me and to others. Negative rates were not a panacea, they argued. Well, of course not; no one ever claimed they were. Fed economists also argued that a negative federal funds rate would damage money market mutual funds severely. I and other advocates retorted, “True, but so what?” The companies would not destroy their computer programs or their legal documents. When rates turned positive, they would be right back in business again. These arguments never persuaded a majority of the FOMC, however. In fact, even many years later when the economy collapsed in 2020 under pressure from the COVID-19 pandemic, there was no sentiment on the FOMC to go negative.

The Fed’s second major departure at that fateful December 16, 2008, meeting was to add strong words of commitment to its postmeeting statement: “weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.” In plain English, the Fed was saying “We’re going to keep the funds rate in the range of 0–25 basis points for quite a while.” Two meetings later, the FOMC changed the phrase “for some time” to “for an extended period,” wording it would maintain until August 2011 when it started referring to possible end dates (e.g., “at least through mid-2013”). The clear intent of each version of this evolving forward guidance was to flatten the yield curve. According to the well-known expectations theory of the term structure, reducing expected future short-term interest rates should bring down today’s long-term interest rates.8 The FOMC was trying to talk the yield curve down by managing expectations.

Over the coming years, the Fed would continue to experiment with various forms of forward guidance. Notably, in January 2012 it began offering market participants its now-famous “dot plot,” showing where FOMC members expected (or was it wanted?) the funds rate to be over the next few years. In December 2012, the FOMC statement switched from using dates to using economic conditions as indicators of when it might start raising rates, following suggestions made earlier by Charles Evans, president of the Federal Reserve Bank of Chicago.

But by the January 2014 meeting, which was Janet Yellen’s first in the chair, the FOMC was dissatisfied with that approach too. It adopted instead purely qualitative forward guidance by declaring that “it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends.” When would that end be? Nobody knew. As it turned out, QE3 ended in October 2014, and the “zero” interest rate policy continued until December 2015.

The third major departure on December 16, 2008, was an FOMC promise to expand its balance sheet further, in several dimensions. It would “expand its [QE1] purchases of agency debt and mortgage-backed securities” and was “evaluating the potential benefits of purchasing longer-term Treasury securities.” That was classic Fedspeak; experienced Fed watchers knew those words meant that the FOMC would soon be buying Treasury notes and bonds for sure. Finally, the FOMC would also begin making nonrecourse loans to entities that purchased private assets under its new Term Asset-Backed Securities Loan Facility (TALF) “early next year.” In fact, TALF lending operations began on March 3, 2009. (More on TALF just below. Suffice it to say here that none of these troubled assets were ever “put” to the Fed.)

Markets stood up and cheered the Fed’s aggressive trifecta. The S&P 500 soared by 5 percent that day. The good news was that Bernanke, the expert on the Great Depression, and the FOMC doves were now firmly in control of monetary policy. The Fed’s hawks went along reluctantly, the dire outlook having overwhelmed their usual conservatism.9

The Fed’s Alphabet Soup

While the FOMC would not push the funds rate below the 0–25 basis points range, expansionary monetary policy didn’t end there. Before the crisis was over, the central bank would create and in several cases generously fund an alphabet soup of new lending facilities designed first to provide liquidity, then to prevent markets from collapsing, and finally to support asset prices. Three of these facilities have been mentioned already: the Term Auction Facility to make loans to banks, the Term Securities Lending Facility to ease liquidity strains at primary dealers, and the Primary Dealer Credit Facility to provide credit to those same dealers. But that trio was just the warmup act. The Fed really swung into action after Lehman Day.

The flurry of activity began with the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF)—quite a mouthful. When the AMLF opened for business on September 22, it was sorely needed. Shortly after Lehman went bankrupt on September 15, markets had learned that the Reserve Primary Fund, the world’s oldest money market mutual fund, had invested heavily in Lehman’s commercial paper, which was now worthless. As a result, the Reserve was forced to “break the buck,” that is, to redeem shares at less than their $1 face value, specifically at 97 cents on the dollar. A 3 percent loss may not sound like much compared to other asset-market calamities that were happening at the time, but money funds were then and are now thought to be 100 percent safe. The Reserve’s surprise announcement therefore precipitated a panic. Dominoes began to fall.

Other money market mutual funds were the first big domino, and I do mean big. In September 2008 these funds held $3.4 trillion in assets, roughly equal to half of all deposits held in banks secured by the Federal Deposit Insurance Corporation. Furthermore, investors thought of money market mutual fund shares as riskless, like bank deposits. So, seeing the Reserve Primary Fund’s shares drop to 97 cents on the dollar felt like losing money in your checking account—but without any deposit insurance to make up the missing 3 cents. A run on money funds ensued, and within a week investors had withdrawn about $350 billion. That run, in turn, forced fund managers to liquidate an equal volume of commercial paper (CP), T-bills, or whatever else they owned. But after the Reserve’s well-publicized losses on Lehman CP, not many buyers were eager to acquire CP. Prices for this formerly ultrasafe security dropped like a stone, and new issuance fell sharply.

Most ordinary citizens had never heard of commercial paper, but to financial aficionados these developments struck at the heart of the system. Many of America’s biggest companies rely on CP for short-term borrowing to tide themselves over routine gaps between payments and receipts, such as large outflows on paydays. Stories arose that even blue-chip companies such as General Electric and IBM might be unable to make payroll.10 Memories of those fears were probably what was on Ben Bernanke’s mind when he later recalled that, “We came very close to a total financial meltdown” (FCIC 2011, 358).

Both the Treasury and the Fed reacted quickly to the impending disaster. As mentioned earlier, the Treasury raided the Exchange Stabilization Fund on the thin rationale that because some of the skittish money fund investors were foreign, “a collapse of the money fund industry could easily lead to a run on the dollar” (Paulson 2010, 253). The Fed pitched in by establishing the aforementioned AMLF to make nonrecourse loans at low interest rates to banks that were willing to purchase high-quality CP from money funds. By October 8, the AMLF had outstanding loans of almost $150 billion. Together, the Treasury’s guarantee program and the Fed’s AMLF successfully ended the run on the money market funds.

But the battles to save the money funds and the CP market did not end there. On October 7, the Federal Reserve Board invoked Section 13(3)—the emergency lending clause of the Federal Reserve Act—to justify creating the Commercial Paper Funding Facility (CPFF). In the Fed’s words, its purpose was to “provide a liquidity backstop to U.S. issuers of commercial paper” (Federal Reserve System, Board of Governors 2008). The CPFF was followed just two weeks later by the announcement of the Money Market Investor Funding Facility to facilitate the sales of money market instruments in the secondary market, but that additional funding mechanism turned out never to be needed.

The CPFF marked a critical turning point in the Fed’s thinking and actions. Providing a “liquidity backstop” and “facilitating” secondary market sales sound innocent enough, but the Fed was now prepared to purchase CP outright through special purpose vehicles created expressly for that purpose. In doing so, the central bank would cross a line by, in essence, buying corporate debt instruments that private markets were shunning, including even paper issued by nonfinancial companies such as General Motors and General Electric.

As things turned out, the Fed made a good bet, turning a profit of over $5 billion on its CP purchases. But profit wasn’t the objective. The Fed was trying to stanch the bleeding, which it did. The market for CP stabilized and started functioning again. Investors who had refused to deal with even the bluest-chip counterparties returned to the CP market, reassured by the Federal Reserve backstop. Loan balances in the CPFF eventually peaked at $350 billion. But by February 2010 the market no longer needed life support, and CPFF loans fell below $9 billion.

Few people realized it at the time, but the successful effort to nurse the CP market back to health marked a crucial conceptual and operational turning point in the Federal Reserve’s approach. Prior to the CPFF, the Fed’s policy focus was—by necessity—on saving (or not saving) specific institutions: Bear Stearns, yes; Lehman Brothers, no; AIG, yes; and so on. Each intervention was ad hoc, and the markets had a hard time discerning any pattern or guiding principles. For example, why save Bear but not Lehman, a question that lingers even today? But with the CPFF, the Fed turned to saving markets. Commercial paper was the first test case, and it worked. Asset-backed securities would be the next.

The asset-backed securities (ABS) markets had all but shut down in the Panic of 2008. On November 25, the Fed announced its intention to establish the Term Asset-Backed Securities Loan Facility (TALF) to support the issuance of ABS collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration. By this time the TARP was in operation, so the Treasury put up $20 billion in TARP money to backstop any losses incurred by what would be a $200 billion Fed facility.11 The lines between monetary policy—if you classified the TALF as monetary policy—and fiscal policy were blurring.

On that same day and back clearly within the domain of monetary policy, the Fed announced its first quantitative easing (QE) program: large-scale purchases of debt obligations of and mortgage-backed securities backed by the government-sponsored entities, mainly Fannie Mae and Freddie Mac. For a central bank that had long restricted its open-market operations to treasuries, QE1 was an adventurous foray into securities that while still quite safe could not be called 100 percent riskless. Since the Fed would be buying these securities outright, not making loans to help others buy them, losses—though very unlikely—were possible. The Fed’s press release that day envisioned $600 billion in eventual purchases, but history records that after several subsequent rounds of QE, the Fed’s ownership of mortgage-based securities (MBS) rose to a peak of about $1.75 trillion in 2015.

Importantly, both the Fed and market participants thought of the new program as rescuing the moribund MBS market or perhaps resuscitating it, since there were hardly any private-sector buyers left. Thus, the Federal Reserve was doing through TALF and MBS purchases something close to what Paulson and Bernanke had decided not to do with TARP money: purchase “troubled assets.”12 QE1 was clearly intended to reduce the interest rate spreads of MBS over treasuries, and it worked marvelously. MBS spreads plummeted from post-Lehman highs around 175 basis points back down to below their precrisis highs by May 2009 (figure 14.2). It was eye-opening to see what a deep-pocketed buyer could do to a dead market. Home mortgage interest rates naturally fell too.

When the Fed moved on to QE2 in late 2010, its large-scale asset purchases were limited to medium- and long-term Treasury securities. The clear intent was to push down longer-term Treasury rates and with them other long-term interest rates, that is, to flatten the yield curve. Curiously, even though no private assets were involved in QE2, it turned out to be the most politically controversial of all the QE programs. Bernanke and the Fed were attacked from directions as diverse as noted monetary policy experts, Sarah Palin (John McCain’s 2008 running mate) and Texas governor Rick Perry, and the German finance minister Wolfgang Schauble, who should have known better.

FIGURE 14.2. Interest rate spreads of mortgage-based securities over treasuries, 2007–2012. (Option-adjusted spread over a corresponding treasury.)

Source: Bloomberg Barclays U.S. Mortgage-Backed Securities Index.

When I defended Bernanke and the Fed in a Wall Street Journal column, I was myself attacked by Palin, who argued that “it’s time for us to ‘refudiate’ the notion that this dangerous experiment in printing $600 billion out of thin air, with nothing to back it up, will magically fix economic problems” (Blinder 2010, A17; Palin 2010). It was as if Palin and others had just discovered that central banks have the power to create money and decided they didn’t like it.

The furor over QE2 surprised and puzzled Fed policy makers. The policy was decidedly less radical than, say, QE1; after all, central banks have been buying (and selling) government bonds forever. It was telegraphed well in advance, so the markets barely moved when it was announced. Yet the political furor was loud and long. Some observers even believe that it made the Fed more timid in contemplating further rounds of QE, an idea supported by the fact that the Fed’s next program of asset purchases, nicknamed Operation Twist, entailed buying long bonds but selling shorts in equal amounts, thus not expanding the Fed’s balance sheet. Whatever the rationale, when the FOMC announced QE3 in September 2012, it limited itself to MBS.

Ben Bernanke (1953—)

The Right Man at the Right Time

Ben Bernanke is a brilliant but unassuming man whose intellectual background made him a perfect fit for the job of Federal Reserve chair when it fell to him to keep America from falling into Great Depression 2.0. But neither he nor anyone else knew that when he first assumed office on February 1, 2006.

Bernanke was raised in the small town of Dillon, South Carolina, where his father, uncle, and mother ran a pharmacy. A precocious child, Bernanke spent only two weeks in first grade before his teachers advanced him to second grade. At age eleven he won the state spelling bee but stumbled in the National Spelling Bee over the word “edelweiss.” (The youngster from small-town South Carolina had never seen The Sound of Music.) That failure was probably his only one in nineteen years of schooling. Young Bernanke taught himself calculus, achieved the highest SAT score in the state, graduated as valedictorian of his high school class, and headed off to Harvard, which was a long way from Dillon both geographically and culturally.

Bernanke’s stellar performance at Harvard easily landed him a spot in MIT’s PhD program, the best in the world. There he again excelled, learning Keynesian economics and much else from the likes of Paul Samuelson, Robert Solow, and Stanley Fischer. The latter actually pushed Bernanke to read Friedman and Schwartz’s Monetary History of the United States, and Bernanke was hooked. As a star PhD graduate in 1979, he had his choice of attractive academic offers and chose Stanford’s Graduate School of Business before moving on to Princeton in 1985. There, over the next seventeen years, he became an academic superstar, chair of the economics department, and a member of the Montgomery School Board in New Jersey. The latter apparently clinched the deal when President George W. Bush was considering him for the Federal Reserve Board (Bernanke 2015, 50).

Bernanke left Princeton in 2002 to accept a position as a governor of the Federal Reserve System. After about three years there, he moved briefly to the White House as chair of President Bush’s Council of Economic Advisers, from where as a Bush “insider” Bernanke was a natural choice when Alan Greenspan’s term expired in 2006.

Bernanke’s eight years at the Fed’s helm were tumultuous, innovative, and controversial. Under his leadership, the central bank dropped interest rates to (almost) zero, created multiple new lending facilities that stretched the Fed’s scope and capabilities, made major increases in transparency (including holding press conferences), and officially adopted a 2 percent inflation target. Most of all, Bernanke and his colleagues, with help from the fiscal authorities, averted Great Depression 2.0. All in all, a pretty consequential chairmanship.

By the end of 2012, the Federal Reserve had stood up the TAF, TSLS, PDCF, AMLF, CPFF, MMIFF, TALF, QE1, QE2, and QE3 (and this list omits a few minor items). All in all, it was impressive display of central bank firepower and of the Fed’s willingness to use it.

The Riverboat Gamble

Many economists, including this author, credit the end of the financial crisis and the Great Recession to a trio of important policy initiatives. The TARP was one. The 2009 fiscal stimulus program, which will be taken up in the next chapter, was another. The third member of the triumvirate was the bank stress tests. And unlike the other two, it neither busted the federal budget nor put taxpayers’ money at risk.

The stress test initiative began inauspiciously on February 10, 2009, just twenty days into the new Obama administration, with what became known as Secretary Tim Geithner’s “deer in the headlights” speech. Geithner is a man of many talents, but giving a speech is not one of them. To make things worse, he had been sandbagged the night before by President Obama, who had inadvertently announced in a nationally televised press conference that his treasury secretary would provide the details of the administration’s new banking plan the next day. “What?,” Geithner must have thought as he watched his TV. He knew the plan was not ready.

When he faced the press the following day, the rookie treasury secretary must have felt like a Christian thrown to the lions. He was, by necessity, painfully short on details, and he seemed a bit unsteady, even flummoxed. (Who wouldn’t have been under those circumstances?) Geithner’s speech was widely panned. The stock market reacted by falling 5 percent that day, not because of any bad news but instead because traders had not heard enough news. Worse yet, stock prices continued to drop for about a month after that, declining by a frightening 22 percent before they finally hit bottom. Welcome to Washington, Mr. Geithner!

The big irony about Geithner’s much-decried February 10 speech is that he actually did announce (without details, of course) what turned out to be a decisive step in bringing the acute phase of the financial crisis to an end: the stress tests of nineteen major financial institutions,13 which was a joint exercise of the four bank regulatory agencies, led by the Federal Reserve. Once the stress tests were complete and the results were announced publicly, it was mostly uphill from there for the financial system.

In announcing the stress test idea on February 10, Geithner said, “First, we’re going to require banking institutions to go through a carefully designed comprehensive stress test, to use the medical term. We want their balance sheets cleaner, and stronger. And we are going to help this process by providing a new program of capital support for those institutions which need it” (U.S. Department of the Treasury 2009). Sketchy, for sure. But the last sentence, “we are going to help this process by providing a new program of capital support for those institutions which need it,” was both a promise and a threat. Both aspects were vital. If a bank failed its stress test and could not raise enough fresh capital on its own, it would receive an infusion of capital from the Treasury using TARP money but with plenty of unpleasant strings attached.

Here is how the stress tests worked. Regulators designed an adverse hypothetical scenario lasting two years and then told banks what loan loss rates to assume under such stressful macroeconomic conditions. The banks were then allowed to net those projected loan losses against projected profits over the two-year period. The net result was an estimated increase or decrease in capital for each bank. Regulators then judged whether each bank’s existing capital was enough to get it through the high-stress scenario. With its promise to be the capital provider of last resort, the U.S. government now stood solidly behind these nineteen institutions. They were all now too big to fail, which reassured markets. Moral hazard considerations could wait for calmer times.

Few people in February 2009 imagined how important the bank stress tests would prove to be. But many observers perceived the high-stakes nature of the gamble. If the capital needs estimated by the stress tests looked suspiciously low, as later happened with Europe’s initial stress tests, markets might conclude that the government was covering up deeper problems or, worse yet, had lost its grip on reality—and therefore panic. On the other hand, if the stress tests generated capital needs that looked beyond banks’ ability to raise new capital, markets might conclude that the banking system was headed for either oblivion or nationalization—and therefore panic. For the stress tests to ease market anxieties, the numbers would have to be, as in the tale of Goldilocks and the three bears, just right.

These risks were heavily debated inside the Obama administration, with National Economic Council director Larry Summers particularly concerned and Secretary Geithner and his lieutenant, Lee Sachs, pushing to go ahead (Scheiber 2012, 124–29). As it turned out, the administration and the Fed hit the jackpot. When the stress test results were made public on May 7, 2009, nine of the nineteen banks were found not to need any additional capital at all. In most of the other ten cases, the estimated capital shortfalls were small enough to fall well within the bank’s capabilities. Aggregated across all nineteen institutions, the total capital shortfall was “only” about $75 billion, a number that didn’t look big when stacked up against the $180 billion bailout for AIG, the $700 billion TARP, and the $787 stimulus bill. Of that $75 billion, about $34 billion belonged to one bank, the Bank of America. The message from the government was therefore clear: large U.S. banks could now be trusted; you could deal with them without fear.

Just as important as the bottom-line capital numbers, however, were the details that accompanied the report on the stress tests, including specifics on how the tests were conducted and a surprising level of detail about the financial condition of each bank. That bank-by-bank information was an eye-opener to aficionados because, prior to the stress tests, bank supervisory data were guarded like nuclear secrets. The bank-by-bank detail created a whole new level of transparency, and that transparency added immensely to the credibility of the whole operation. Yes, the regulators got the stress tests just right, and confidence began to return.

Few people realized it at the time, but the successful stress tests were a major turning point. They relieved a lot of stress. They also marked the end of the acute stage of the financial crisis and the beginning of the return to normalcy, albeit just the beginning. Most bank stocks rose after their test results were made public, and it wasn’t long before everyone stopped worrying about the survival of America’s biggest banks. “Monetary policy” had expanded both its reach and its grasp.

Chapter Summary

Just about everything regarding the U.S. economy and its financial system went south in the weeks that followed the Lehman Brothers bankruptcy in September 2008. It was then that the fiscal and monetary authorities really got serious and pulled out all the stops, grudgingly in some cases. Three big, creative, and highly successful initiatives head the list.

The first, which was started under George W. Bush’s presidency and finished under Barack Obama’s, was the Troubled Assets Relief Program (TARP), a misnamed (as it turned out) effort to get dodgy mortgage-related assets off the books of damaged financial institutions. The immense magnitude of the program, which was budgeted at $700 billion, was stunning at the time. And the purpose—which the media characterized as “bailing out” banks—was seen as politically poisonous. Congress balked at first but then, after the stock market tanked, passed the TARP bill with alacrity. Shortly thereafter, Secretary Hank Paulson announced that TARP money would not be used to buy “troubled assets” after all but rather to buy shares in banks. It turned out to be a bank bailout after all.

One interesting question for this book is whether the TARP constituted fiscal policy or monetary policy. In the conventional sense, it was neither. TARP was not about cutting taxes, spending money, or reducing interest rates. Rather, it was about putting taxpayer money at risk by purchasing assets that might decline in value, such as preferred stock in banks. The program was also designed jointly by the Treasury and the Federal Reserve. So, was it monetary policy then? No, though its firepower was squarely aimed at the financial system. Rather, the TARP was a hybrid that is best thought of as financial stability policy, something the U.S. government had not needed since the Great Depression (but would need again in 2020).

The second big initiative was the bank stress tests, which were announced in February 2009 and completed that May. Once again, this program was neither fiscal policy (though it could have had fiscal implications if Treasury payouts had proven necessary) nor monetary policy but rather financial stability policy. And once again, the stress tests were a joint product of the Treasury Department, which announced it, and the Federal Reserve, which carried it out (along with other banking agencies). Importantly, the transparency of the stress tests convinced markets that the capital hole in the U.S. banking system was of manageable size, and confidence returned.

These two major financial stability initiatives, each involving extensive cooperation between the Treasury and the Fed, helped restore the financial system to health. Coupled with the hundreds of billions of dollars in fiscal stimulus that will be discussed in the next chapter, the three aggressive policy interventions helped get the U.S. economy moving uphill again in June 2009. The downturn proved to be smaller and less long-lived than pessimists had assumed, and the expansion that began in June, though it started slowly, would eventually shatter all records for longevity. The unorthodox policies also, of course, left a lasting imprint on the relationship between the Fed and the Treasury.

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1. The Exchange Stabilization Fund was created in 1934 to stabilize the dollar exchange rate, which was certainly not the problem of the day.

2. Some people, myself included, found this belief naive under the circumstances. Why would banks be so venturesome? Wouldn’t they use the new capital to bolster their ailing balance sheets rather than engage in more risky lending? For further discussion of this issue, see Blinder (2013, chap. 7).

3. Notice that the law did not require his approval, only that there be consultation.

4. Though the technical problems required thought, they were not insoluble. Swagel (2009, 55) reported that “we had reverse auctions to buy MBSs essentially ready to go by late October 2008—including a pricing mechanism.”

5. The words “very close” connote the fact that the Fed did not buy the troubled assets itself but rather made loans that enabled other entities to buy them. The legal distinction was important under the Federal Reserve Act. The economic distinction was far less clear.

6. Two examples: Restraints on executive compensation were minimal, and the dividend rate on the government’s preferred stock would be a mere 5 percent, half of what Warren Buffet had just charged Goldman Sachs.

7. One of these occasions was in front of a huge audience at the Economic Club of New York on November 20, 2012 (Bernanke 2012a, 24–26). There were many others, both in public and in private.

8. The theory is extremely well known and often taken as gospel even though virtually every empirical test has refuted it! See, for example, Campbell and Shiller (1991). Numerous other empirical studies have reached the same conclusion.

9. David Wessel (2009, 257–58) reported that Richard Fisher, president of the Federal Reserve Bank of Dallas, initially lodged a dissent but then withdrew it. The reported vote was therefore unanimous.

10. Sorkin (2010, 420) reports a conversation with GE’s CEO, Jeffrey Immelt, to that effect.

11. Without TARP, the Treasury had refused to backstop the CPFF.

12. To be sure, these were among the least troubled of the “troubled assets.” Fannie and Freddie MBS carried far less risk than, say, private-label MBS. Also, as noted above, in the TALF the Fed was just lending against troubled assets, not buying them.

13. These were not all banks. The list included GMAC, MetLife, Goldman Sachs, and Morgan Stanley. MetLife had become a bank holding company when it acquired a New Jersey bank in 2001.The other three, seeking shelter from the financial storm, had become bank holding companies hurriedly in 2008.

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