Bull by the Horns

by Sheila Bair

  Unfortunately but predictably, Reich responded that he did not necessarily agree with the FDIC view. He argued that the willingness of a private-equity firm to make a capital investment indicated that WaMu was in a stronger position than Chase’s offer suggested. In the end, the WaMu board rejected Chase’s offer of $8 a share. Instead, the company sold TPG $7 billion worth of newly issued common and preferred stock. The TPG deal also allowed the Killinger management team to keep their jobs and reinstated Bonderman to the WaMu board.

  Though I was not convinced that the WaMu board had fully considered both options, I was very relieved to see a fresh $7 billion capital infusion. Earlier reports we had received from the OTS had indicated that TPG would invest only $5 billion, which our examiners believed was far too low to provide an adequate cushion against WaMu’s escalating mortgage losses. The market also reacted positively, though analysts’ commentary included56 a healthy dose of skepticism about whether $7 billion was enough capital to see WaMu through. Indeed, for context, another bank on our “worry list”—NatCity—acting under intense pressure from the OCC—had also raised $7 billion in new capital, even though NatCity was half WaMu’s size.

  For a while, at least, the situation at WaMu seemed to be stable. We increased our backup examination presence at WaMu while concentrating on some of the other regional thrifts that were deteriorating fast. We were also busy monitoring the growing number of community banks that were getting into trouble with their commercial real estate loans. The FDIC kept a list of “troubled banks,” which essentially was a list of banks whose primary regulator had assigned a CAMELS supervisory rating of 4 or 5. They were banks we viewed as being at heightened risk of failure and requiring more intensive supervisory attention. Each quarter we published the number of banks on the list as well as the total amount of banking assets represented by the group. In 2006, when I came to office—at the tail end of the “golden era of banking”—the list stood at fifty, representing $8 billion in assets. By the end of 2007, the list had jumped to seventy-six, representing $22 billion in assets, and we predicted that it could go as high as $885 billion by the end of 2008. We had already experienced three failures in 2007 after nearly three years of no bank failures at all and projected that another eleven banks would fail before the end of the year.

  I had mixed feelings about our troubled-bank list. On the one hand, I thought the public had a right to know about the basic health of the banking industry, and our troubled-bank list was a long-used public indicator. On the other hand, the list could be misleading, as it was clear that it lagged the true health of the industry. Indeed, we thought our failure projections in the first quarter of 2008 were aggressive, but as it turned out, they understated the risks significantly. One problem was that the list was based on examination ratings, which were refreshed only once a year for most institutions, in accordance with examination schedules. But more important, it was clear to me that the OCC and OTS were reluctant to downgrade their larger institutions. Downgrading a bank was, to some extent, an acknowledgment of weakness in the examination program. Ideally, if examiners were on their toes, they would intervene and take measures to stabilize a bank before it ever reached troubled status. (Such interventions typically included regulatory orders for banks to raise capital, stop weak lending practices, or hire new management.) In addition, because we publicly disclosed the total dollar amount of troubled-bank assets, placing a large bank on the troubled list could start a market guessing game about which large institution had been added. And in retrospect, it is clear to me that the OCC was not giving us information that truly reflected the severity of problems at two of its biggest banks, Citi and Wachovia.

  An early case in point of that phenomenon was IndyMac Bank, yet another OTS-regulated West Coast mortgage lender. IndyMac was everything an insured bank shouldn’t be. It had very little in the way of “core” deposits, meaning that it didn’t have many true bank customers who actually had a relationship with the bank; rather, most of its deposits came by offering above-market rates on deposits through third-party brokers. It also borrowed excessive amounts of money from the Federal Home Loan Banks (FHLB) system. And it made some of the most toxic mortgage loans in the country. It specialized in interest-only loans and option ARMs originated through mortgage brokers with little or no income documentation. Though by the end of 2007, our staff projected that it would fail before the end of 2008, OTS had failed to downgrade it to troubled status.

  We did finally convince OTS to downgrade IndyMac in the second quarter of 2008 and began planning a resolution strategy for the fourth quarter. However, on June 26, John Reich and I received letters from New York Democratic Senator Chuck Schumer stating “I am concerned that IndyMac’s financial deterioration poses significant risks to both taxpayers and borrowers” and that the bank “could face a failure if prescriptive measures are not taken quickly.” The impetus for that provocative letter and Senator Schumer’s decision to make it public remain a mystery. However, it spooked the heck out of IndyMac depositors and prompted a major bank run. Between June 27 and July 11, depositors pulled out $1.3 billion in deposits. In addition, the Federal Home Loan Banks pulled IndyMac’s credit lines. IndyMac was quickly running out of cash. We worked with the OTS on an emergency closing on Friday, July 12. Without time to auction the bank in advance, as was our usual practice for bank failures, we set up a “bridge” institution to keep the bank operational and preserve what little franchise value it had. It was extremely difficult to find buyers for the institution, given its high-cost deposits and toxic mortgage loans. The ultimate price tag for IndyMac’s failure: more than $7 billion, by far the most expensive bank failure for us of the crisis.

  IndyMac was a major learning experience for me on a number of fronts.

  First, I learned that we should never let the primary regulator close a bank before the close of normal business hours. OTS had decided to close IndyMac three hours early to give John Reich time to call members of Congress while they were still in their offices. Waiting until IndyMac’s normal closing time of 6 P.M. Pacific Time would have meant that he was calling congressional members at nine at night. (It was common courtesy for regulators to notify the chairmen and ranking members of the banking committees of significant bank failures.) When told of this plan by our resolutions team, my chief of staff, Jesse Villarreal, questioned the timing, noting that people would still be going to the bank, expecting it to be open.

  I wish I had intervened with OTS, because Jesse was right. As it turned out, word of the closure spread like wildfire as soon as the OTS and FDIC staff showed up to take the institution over. The news media showed up within minutes. Customers expecting the bank to still be open were terrified by the locked doors and media circus filming their every move. Throughout the weekend, the cable news played a video of a panicked, tearful woman banging on the door trying to get in to close her account. That never would have happened if we had just told OTS to wait until the bank closed. After IndyMac, I put a firm policy into place that no banks would be closed before their regular closing time.

  Second, I learned how sensationalistic and irresponsible the media could be—particularly those that are not accustomed to covering financial issues. Driven in large part by the media hype, by Saturday morning, bank customers were lined up for blocks in the California heat, trying to withdraw their deposits. Incredibly, we were seeing a bank run after it had already closed and was under FDIC control. At that point, it was probably the safest place in the world for depositors to keep their money.

  Many of those in line were uninsured depositors. Unfortunately, there was a significant amount of uninsured deposits at IndyMac, about $1 billion. Those deposits were going to have to take some losses, or “haircuts,” under our rules to help cover part of the FDIC’s costs. Insured deposits were paid out immediately, but half of the uninsured money was held back. There were some really heartbreaking stories about many of those uninsured accounts: the mother of an Afghanistan soldier
killed in action who had deposited all of his life insurance, a policewoman who had just sold her home and had deposited the proceeds. Yes, our rules—which were governed by statute—required us to impose losses on uninsured deposits, and it is incumbent on people to know the FDIC deposit limits and stay below them. (But, as will be discussed later, the same can be said for the bondholders and counterparties of large financial institutions. They should have expected to take losses. Instead, they were bailed out in full.)

  Andrew Gray, our head of public affairs, was on the phone continuously with the press trying to get it to balance its stories with a public reassurance that FDIC-insured deposits were safe. The FDIC has a very strong record in this regard. No depositor has ever lost a penny of insured deposits. Never. We had already launched a media campaign celebrating our seventy-fifth anniversary. Given the increased public uncertainty about the safety of the banking system, we thought the seventy-fifth anniversary would provide a good opportunity to remind people about the FDIC’s rock-solid guarantee that would protect their insured deposits no matter what. After the IndyMac failure, we redoubled our efforts to educate the public to counter the fearmongering that we were seeing among some of the more ill-informed members of the press corps.

  Not only were those fearmongers seizing on the increasing fragility of the financial system, they were also starting to scare people about our financial capability to fully protect depositors in the event of wide-scale bank closings. The IndyMac failure was horrifically expensive and had put a huge dent in the fund we maintained to cover the cost of bank failures. Over industry opposition, upon assuming office, I had forged ahead with increasing deposit insurance premiums to build our financial resources, but by the summer of 2006, it was too late to accumulate a meaningful extra cushion before the mortgage crisis hit and our losses started to mount.

  Under our accounting rules, the FDIC projects the number of likely bank failures over the next twelve months and their cost, and then deducts that amount from the fund we maintain to back our insurance guarantee. In the second quarter of 2008, the Deposit Insurance Fund had declined to $45.2 billion from $52.4 billion just a year earlier. However, we had already set aside more than $7 billion to cover our likely losses from IndyMac and other banks and thrifts that we thought would fail over the next year. That money was in a special account called a “contingent loss reserve” (CLR). Families do much the same thing when they know they have an upcoming expense such as school tuition, an insurance payment, or property taxes. From the perspective of managing a household budget, it sometimes helps to put committed money into a separate account to make sure it is not used for other purposes. Our contingent loss reserve served a similar purpose.

  The media would consistently ignore the amount we had in that special account—the CLR—and instead focus on the DIF, which was declining rapidly. (By the end of 2008, it had plummeted to $17.3 billion, and by 2009, it was in negative territory, though our total reserves, which included the CLR, always remained positive.) It was a more sensational story to suggest that the FDIC was running out of money than to accurately account for our total resources, which included the CLR. Of course, even if we had run out of money (which we never did), we had the power to impose additional assessments on the industry as well as borrow from the Treasury. The FDIC guarantee is statutorily backed by the full faith and credit of the United States. We were the government, and the only way we could run out of money was if the Treasury Department or Congress refused to honor our “full faith and credit” obligations. That would be tantamount to a U.S. government default, and it just wasn’t going to happen.

  But all of that was overlooked in the sensationalistic coverage of the burgeoning financial crisis. Dealing with media and public inquiries about our financial resources became a daily task for me and our press office. I will never forget getting onto a plane to go to Phoenix to speak to a community banking group. I was sitting in coach, as I always did on domestic flights. (Those movies showing senior government officials in first class and private planes are la-la land.) Another passenger boarding, a young man in his twenties, stopped in the aisle, looked down at me, and asked if I was Sheila Bair, the chairman of the FDIC. When I said yes, he stated in a quite loud voice, “Holy cow! You must be running out of money if they have you sitting in coach.” I replied in an equally forceful voice, “No, we have plenty of money. Your deposits are safe, and I always ride coach.”

  Early in my tenure at the FDIC, the late William Seidman, the legendary FDIC chairman who had steered the agency through the S&L crisis, told me that my success in the job would rise or fall on how successfully I handled the media. His words echoed loudly in my head when, every morning, I would peruse our press clips and see at least one article saying that the FDIC was going broke. I gave speeches and media interviews and took a road show through seven major cities to explain our financing to the public and local media. We had a perfect track record in protecting people’s money through thousands of bank failures over our seventy-five-year history.

  I also reached out to Suze Orman, who had a strong brand and trust relationship with the public based on her straight-talking, commonsense approach to personal financial management. Suze agreed to help us set up a new website devoted exclusively to explaining to people how FDIC insurance worked. She and her staff spent days with us providing free help in making the site as user-friendly as possible. She also agreed—again for free—to appear in a series of public service ads (PSAs) assuring people about the safety of their insured deposits. I met her in New York in August 2008 to film the ads. She, of course, had a coterie of wardrobe/makeup/hair specialists (at her own expense) to help her pretty up for the glaring lights and cameras. I, on the other hand, had my teenage son, Preston, with me to hold my purse while we did the shoot. She offered to let her “beauty team” work on me. I said sure. I’ll never forget her hairstylist, a Russian gentleman. He asked me if it was okay to take a little off the sides of my below-chin-length hair. I said sure. After thirty minutes—and a significant amount of my hair tumbling to the floor—he pulled out his blow-dryer and started styling away. My back had been to the mirror the whole time, and when he was finished, he whirled me around so that I could see the masterpiece. My hair was exactly the same style as Suze’s except parted on the other side. If you watch the PSAs, you can see that we look like the mirror image of each other. My kids called it my “Suze-do.”

  Ultimately, our public education campaign was successful. Not only did people leave their insured deposits in the banks, but insured deposits started growing as a result of the public’s faith in us. However, other bank creditors who were not protected by us, including uninsured depositors, started to withdraw their money from institutions viewed as being at risk of failure. That was particularly true for institutions that, like IndyMac, had large exposures to high-risk mortgages on the West Coast.

  WaMu was hit particularly hard. Deposit outflows averaged $1.2 billion a day during the first week after IndyMac’s failure; the following week they averaged $750 million a day, tapering down to average withdrawals of $550 million a day the week after. Wachovia (because of its misguided purchase of Golden West) was also hemorrhaging deposits, but for whatever reason, its primary regulator, the OCC, did not alert us to that fact until much later on. (By July, we had put our own monitors into WaMu but not Wachovia, based on the OCC’s assurances that it was in sound condition.) WaMu’s deposit outflows tapered off after the fourth week but continued at elevated levels. In addition, depositors started restructuring their uninsured deposits into insured accounts, by, for instance, setting up trust accounts or separate accounts in other family members’ names. To make up for the lost funds, WaMu started borrowing much more heavily from the Federal Home Loan Banks.

  Receiving daily reports about WaMu’s deposit outflows made me physically ill. All of those events would dramatically increase the FDIC’s costs if WaMu failed.

  A bank can essentially fail in one of two ways: It can b
ecome insolvent, meaning that the amount of capital it has is insufficient to cover its losses on its loans and other assets. That is why regulators watch each bank’s capital ratios very closely; when it dips below 2 percent, federal law requires that the regulators close the bank within ninety days, unless it can raise more capital. As we learned during the S&L crisis, insolvent institutions need to be closed quickly to minimize losses. If a failed institution is left open, the management will typically get deeper and deeper into high-risk lending in an attempt to generate fat returns to dig their way out. But those high-risk loans end up generating even more losses. That is exactly what happened during the S&L crisis, and the cleanup cost the taxpayers more than $125 billion.

  A bank can also suffer a liquidity failure. That essentially means that it runs out of money to meet its obligations, including deposit withdrawals. A bank nearing insolvency will frequently fail because it runs out of cash, even though it is technically still solvent. The market anticipates that its capital base is insufficient to absorb likely losses, so creditors will try to pull out early, before the failure occurs. Some creditors—such as insured depositors and those holding collateral to secure their loans—are protected in an FDIC resolution. However, unsecured creditors, including uninsured depositors, are not. So they are the first57 to try to pull out when it looks as though a bank is running into trouble. They want to escape whole because they know they will take a haircut if the FDIC has to take over. That increases the FDIC’s costs in two ways.

  First, in an FDIC resolution process the failing institution will typically have to replace the uninsured deposits or unsecured loans with other sources of funding that are protected from loss: in the case of WaMu, uninsured deposits and unsecured loans were being replaced with insured deposits and loans secured with collateral. For instance, the FHLBs lend only on a secured basis and typically demand a bank’s best loans as collateral for their lending. When the bank fails, the FDIC must turn all of that collateral over to the FHLB. We cannot sell those high-quality assets to recoup our losses, so our costs for a bank that relies heavily on FHLB loans are typically quite high, as we saw with IndyMac.