Bull by the Horns

by Sheila Bair

  I was particularly relieved that the Chase acquisition protected all of the uninsured depositors, particularly given some of the heartbreaking instances of uninsured depositors at IndyMac. However, two groups were not happy: WaMu bondholders and WMI shareholders. WaMu’s failure forced the bankruptcy of WMI within days of the bank closing. WaMu and its parent, WMI, had been in declining health for so long, most of the shares had been dumped onto the market and purchased by speculators, who were betting on a government bailout. That expectation was reinforced when Hank Paulson and Ben Bernanke had gone to Congress several days before, requesting $700 billion to provide troubled-asset relief for U.S. financial institutions. Our phones started ringing off the hook the week following the WaMu failure, mostly irate flippers. I fielded some of the calls myself and couldn’t believe what I was hearing. They were at least honest; they told me that they had purchased WaMu stock at a steep discount when they had seen in the news that Paulson was seeking Trouble Asset Relief Program (TARP) funds and had been expecting to profit when WaMu was bailed out! (At that point, Congress had not yet approved TARP. In fact, the House of Representatives initially voted it down. It was not approved until October 3.)

  That is not to denigrate those who took losses from the WaMu failure. And there were some bona fide purchasers of WaMu stock who took losses. But a lot of people suffered loss as a result of the crisis, and there was no defensible reason for the FDIC to bail out WaMu’s shareholders and creditors, shifting the losses from WaMu’s stakeholders to the government. As has been repeatedly documented by the Treasury and FDIC IGs, the Senate Permanent Subcommittee on Investigations, and the Financial Crisis Inquiry Commission, WaMu had been horribly mismanaged and was a major player in the kind of abusive, unaffordable, and at times potentially fraudulent lending that had driven the subprime mortgate crisis. WaMu’s bondholders and shareholders had a duty to monitor risk taking at the institution and assure management’s accountability. The responsibility was theirs, not the taxpayers’.

  It is amazing to me that those who lost money on the WaMu failure tried to assign blame to the FDIC and Chase, instead of the WaMu management. In truth, Chase stepped up and took a very sick institution off our hands when none of the other bidders would touch it without significant financial support from the FDIC. To be sure, Dimon was acting in the interests of his bank, and he still believes the acquisition was a positive one for Chase. However, there is no doubt that the WaMu acquisition was risky, and dealing with its troubled-mortgage portfolio has been a challenge for the Chase management. If Chase had not acted, the FDIC would have suffered tens of billions of dollars in losses.

  Another criticism of the WaMu resolution—as well as other government-facilitated mergers during the crisis—was that we made already big institutions bigger and thus made the too-big-to-fail problem worse. As a leading critic of the too-big-to-fail doctrine, I am obviously sensitive to this argument, but I think the WaMu transaction has to be viewed in the context of available alternatives. We had no legal authority to bail out the institution absent a systemic risk exception, which required the consent of the Fed, Treasury, and president. I did not think that poorly managed institution should have been bailed out. We could have set up a bridge institution and operated it for a period of time, but eventually we would have had to sell it; the FDIC is not in the business of running banks, nor should it be. Finally, though we were making Chase bigger, we were adding only to its traditional banking operations; WaMu took deposits and made loans. As will be discussed later, the too-big-to-fail phenomenon is more a function of interconnectedness and complexity than of size. A bank—even a very large bank—that is in the business of taking deposits and making loans is “resolvable” without systemic implications because of the ease with which mainstay banking can be transferred to other institutions. So yes, we made Chase bigger, but we did not make it more complex or more difficult to resolve if—down the road—it should ever get into trouble.

  CHAPTER 8

  The Wachovia Blindside

  On the Friday morning after the WaMu failure, we had our weekly conference call from other regulators on the status of high-risk institutions. I was particularly worried about Wachovia, primarily because of its pricey acquisition of Golden West. Golden West had substantial exposure to high-risk mortgages on the West Coast. Amazingly, even after Wachovia had purchased Golden West in 2006, it had continued to make high-risk mortgages. Indeed, the performance of the mortgages Wachovia had originated after the acquisition was significantly worse than that of the loans it had taken over from Golden West. Wachovia had other problems as well. It had made a large number of commercial real estate loans that were experiencing heavy losses. In addition, it had gotten itself into trouble with the SEC by selling high-risk investments called “auction rate securities” to small businesses, charities, and other less sophisticated investors. In August, it had announced a settlement with the SEC that forced it to buy back nearly $9 billion of these investments.

  In June, the Wachovia board had replaced its longtime CEO, Ken Thompson, with Bob Steel, formerly at Goldman, who had served as undersecretary for domestic finance. The bank had also raised $7 billion in new capital over the summer. However, those steps proved to be too little, too late. Wachovia had suffered $32 billion in losses over the previous three quarters. Its share price had plummeted, and its CDS spreads—the cost to an investor of buying insurance protection against a default by Wachovia—had widened considerably. During that Friday-morning call, when we turned to Wachovia’s primary regulator, the OCC, for an update on Wachovia’s position, OCC’s staff told us that the bank’s liquidity was stable. I was surprised but relieved. Having just resolved the $300 billion WaMu, I had no desire to turn around and tackle an $800 billion institution.

  My relief was short-lived. Late Friday evening, I was contacted by OCC head John Dugan, who had been abroad and had not participated in the earlier call. He told me that Wachovia was having some problems and we needed to talk over the weekend. That was followed by an email I received from FDIC senior staff member John Lane early Saturday morning, who had been notified by his counterpart at the OCC, Michael Brosnan, that Wachovia was in serious trouble. Its board had held an emergency meeting on Friday and determined that Wachovia either had to raise capital or merge with either Wells Fargo or Citigroup, both of which had expressed an interest in an acquisition. It had also determined that a capital raise was not feasible, given the current market conditions. Brosnan told John Lane that “the market has turned on them” (counterparties refusing to do business with them) and that the FDIC “should start thinking about contingency planning as Mike said they could only last a couple of weeks on their own.” That was followed by an email from OCC Senior Deputy Comptroller Douglas Roeder to me informing me of a 10:30 A.M. conference call with the OCC, the Federal Reserve Board, and the New York Fed to discuss the Wachovia situation. I asked him if we should include our resolutions staff on the call. He said yes.

  The 10:30 A.M. call was full of surprises. As a number of market analysts had been saying for some time, Wachovia was having serious problems. Tim Geithner, then the head of the New York Federal Reserve Bank, was pushing an FDIC-assisted transaction for Citi to acquire Wachovia. It was obvious that Citi had already had extensive conversations with the NY Fed. Citi even had a specific proposal. It wanted to acquire the institution, with the FDIC providing a “ring fence” over Wachovia’s more troubled assets and absorbing losses if they went over a certain threshold. The proposal sounded to me like a “twofer”—a bailout for Wachovia and a bailout for Citi.

  I was astounded. First, why had the OCC and Fed taken so long to alert us to Wachovia’s problems? Second, why was the NY Fed in discussions with Citi about a Wachovia acquisition, based on the understanding—not shared by others—that the FDIC would help it cover its losses? Wachovia’s CEO, Bob Steel, was in active conversations with Wells Fargo for a privately negotiated acquisition that did not involve any government support.
And I was very concerned that word of the NY Fed’s active engagement with Citi about an FDIC-assisted deal would get out and disrupt the discussions with Wells. Why would Wells want to buy Wachovia completely on its own dime if it thought it could get some help from the FDIC?

  Steel was supposed to have breakfast in New York with Wells Chairman Dick Kovacevich on Sunday morning. After hearing how fragile Wachovia was, I contacted Steel and asked him to keep me posted on the status of the discussions. After the breakfast, Steel reported back that it had gone well. He and one of his top executives, David Carroll, had broken bread in Kovacevich’s suite at the plush Carlyle hotel. The talks had been positive, and Kovacevich had ended the conversation by talking about the share price offer, which he said “could not be in the twenties.” Steel took that to mean that the offer from Wells would be between $15 and $20 a share. He felt good about the breakfast but was disappointed that they had not yet closed the deal.

  I was worried.

  As I relayed in an email to Ben, Don Kohn, John Dugan, and Tim Geithner after my call:

  Just got off the phone with Bob Steel. Things are still going in the right direction with wells, though they are hampered by uncertainty that this perhaps could be a government facilitated deal. It doesn’t help that Citi has told everyone they are looking for government assistance.

  I think it is important for both the fed and the OCC to make clear to both potential bidders that this institution has significant value and the transaction should occur on an open bank, unassisted basis. That is certainly our view.

  To be polite but somewhat pointed about the New York Fed’s advocacy for an assisted deal, I added, “You probably have already done this but I would encourage you to make this clear as soon as possible.”

  For once, John Dugan and I agreed on something. He responded with support: “Understood. . . . We will continue to make these points with both bidders.”

  Steel had asked me to call Kovacevich directly to encourage him to close the deal. I think that Steel, one of the savviest people I have ever met, also feared that the NY Fed might be trying to push Wachovia into Citi’s arms as a backdoor way to bail it out, though the deal would be camouflaged as a way to help Wachovia. If that was the game plan, it would not want a Wells acquisition to go through. My getting involved would help counter the NY Fed. But the risk was that I might compound the problem if I talked to Kovacevich. He might try to engage me about the prospect of FDIC assistance, and I wanted the acquisition to go through without FDIC support. Up to that point, at least, Kovacevich had not even hinted that Wells would need government help. I decided not to make the call.

  How would a Wachovia acquisition help Citigroup? Citi had forayed deeply into the subprime and CDO markets, which were in severe distress. It had suffered four consecutive quarters of losses. It also had a highly unstable funding base; much of its funding came from deposits overseas, which were not covered by strong deposit insurance guarantees similar to those provided by the FDIC. It had very little in the way of domestic deposits that we insured, so our direct exposure to it was quite small. Funding its U.S. assets with foreign deposits kept its deposit insurance premiums low. However, at the same time as Citi’s problems mounted, those foreign uninsured deposits had become highly unstable. Citi needed a domestic insured deposit base to provide it with a stable source of funding. In that regard, Wachovia’s $450 billion in U.S. deposits was highly attractive. But that would also dramatically increase the FDIC’s exposure to Citi.

  I waited all day for word as to whether the Wells acquisition was going through. Little did I know that shortly after Kovacevich’s breakfast with Steel, he had initiated a call with the OCC, NY Fed, and Federal Reserve Board to let them know that he was unwilling to move forward without government assistance. Indeed, I knew nothing about the call until I read about it in David Wessel’s book In Fed We Trust60: Ben Bernanke’s War on the Great Panic. It is amazing to me that given the fragile state of Wachovia and the need for FDIC intervention if the Wells deal came off the table, none of the primary regulators bothered to call and give us a heads-up. (I hasten to add that Ben Bernanke was not on the call and was unaware that we had not been notified.) Was it gross incompetence or unbelievable disrespect? Or was it just the all-boys network wanting to make the decisions among themselves, as many commentators have speculated? Maybe the boys didn’t want Sheila Bair playing in their sandbox. Or, equally likely, they may have wanted to force us to bail out both Wachovia and Citi without imposing losses on market participants, as we had with WaMu. The longer they waited to notify us, the more difficult it would be for us to prepare for a bank closing and find a buyer. Without enough preparation time, a bailout would have to be the default option.

  Late Sunday afternoon, after contacting Steel, who had also been left in the dark, I decided to contact Wells directly. If the deal had gone sour, we needed to start to prepare. I called Warren Buffett to get contact information for John Stumpf, Wells’ CEO. I had always found Stumpf to be professional and direct in my dealings with him, unlike Kovacevich, who was known for his combative, confrontational style. Stumpf told me that the deal was off and acted somewhat surprised that I had not been notified. I thanked him for the information and headed in to the office.

  With the markets coming unglued and Wachovia’s liquidity highly unstable, I felt we had no alternative but to act to facilitate a stabilizing merger before Wachovia opened for business on Monday morning. We could not afford the risk of a disorderly failure if Wachovia could not meet the withdrawal demands of its creditors, including depositors, once it reopened its doors. A bank run on Wachovia could have very well precipitated widespread panic. I notified the other regulators and the FDIC resolution staff that we would be contacting Wells and Citi to solicit bids for an FDIC-facilitated transaction.

  No sooner had I reached the office than I received separate calls from Ben Bernanke and Josh Bolten, President Bush’s chief of staff. The men informed me that the Fed and White House, respectively, would support a systemic risk exception for Wachovia. This was their polite way of telling me not to try to close Wachovia as we had done with WaMu. The argument that Tim and other bailout advocates were making was that because we had imposed losses on WaMu shareholders and bondholders, we had destabilized the market, so we should be prevented from imposing any further losses on bank stakeholders, particularly bondholders. Of course, the facts did not bear that out. The WaMu closing had been virtually a nonevent. They pointed to the fact that the stock market had fallen precipitously on Monday, four days after we closed WaMu. But that had been in reaction to Congress’s failure to pass the TARP legislation, not the WaMu closing, as contemporaneous market analysis clearly demonstrated. If there was a relationship between WaMu’s failure and Wachovia’s problems, it had nothing to do with the fact that WaMu’s bondholders had taken losses; it was because Wachovia had the same type of exposure to toxic loans on the West Coast that had brought WaMu down.

  But that was only the beginning of a profound philosophical disagreement between me and Tim Geithner. He did not want creditors, particularly bondholders, in those large, failing financial institutions to take losses. I did. For years, those poorly managed institutions had made huge profits and gains from their high-flying ways, and large institutional bond investors had provided them with plenty of cheap funding to do so. Their primary regulators, the NY Fed and OCC, had stood by as bond investors extended credit to the behemoths based on the implied assumption that if anything went wrong, the government would bail them out. But we do not have an insurance program for big bond investors. They are sophisticated and well heeled and can fend for themselves. There is no reason for the government to protect them. We do have an insurance program for Main Street bank depositors through the FDIC under a system that requires the FDIC to impose losses on uninsured depositors and other creditors for “nonsystemic” institutions. We charge banks a premium for that insurance coverage, which inevitably is passed on to consumers. Why should
the mother of a soldier in Afghanistan or a policewoman making $50,000 a year have to take losses on their uninsured deposits, while the FDIC bails out big banks and those who have invested in them?

  Late Sunday afternoon, I instructed FDIC staff to talk with Citi and Wells about bidding on either an open- or closed-bank basis. I wanted to at least have some sense of whether a closed-bank deal was possible and what it might look like, to compare against the cost of bailing Wachovia out. However, there were a number of impediments to a closed-bank transaction. For one thing, Wachovia was a bigger and more complex institution than WaMu. It had multiple bank charters and significant operations outside its insured banks, most notably several retail securities brokerages. Using FDIC resolution powers on Wachovia would require that we split up the franchise, resolving the banks and likely sending the holding company and brokerages into bankruptcy. But perhaps more important, the main bank’s primary regulator, the OCC, whose job it was to revoke the charter of a failing institution, flatly refused to do so. John Dugan clearly did not want the embarrassment of a major national bank being closed on his watch. (Indeed, months later, after massive bailouts were required to stabilize two of his largest charters, Citigroup and BofA, he would publicly criticize community bank failures for causing losses to the FDIC while boasting that none of his major banks had been closed.) Given the opposition of the OCC to closing Wachovia, it is hardly surprising that both Wells and Citi refused to bid on a closed-bank basis in defiance of the wishes of their primary regulator.