Bull by the Horns

by Sheila Bair

  Much misinformation has been written about that long night as we worked with Wells and Citi to come up with firm bids. Both Wessel and Andrew Ross Sorkin, in his book Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System—and Themselves, erroneously allege that the night was spent with the other regulators wrangling with me over whether to close Wachovia. Hank Paulson (who was not involved at all in the discussions) asserts that the night was spent with my trying to get the Fed or the Treasury to foot the bill for the bailout. Neither version is true. Having received calls early Sunday evening from both the chairman of the Federal Reserve Board and the White House chief of staff making clear that they wanted a bailout, I saw the writing on the wall. My efforts to try to see what closed bids would look like were quickly stymied by Citi’s and Wells’ refusing to entertain a closed-bank transaction. So I gave up early, and the main reason the negotiations took all night was that Wells took several hours to come forward with a bid and then hours more had to be devoted to analyzing the competing bids and working through the legal and accounting issues associated with the transaction. Our head of resolutions, Jim Wigand; Art Murton, who headed research; and our COO, John Bovenzi, had been in phone communication with Wells all night as Vice Chairman Marty Gruenberg and I sat in my office waiting for the staff to notify us of the winning offer. Finally, I got on the phone with the Wells people directly and, frankly, let them have it. (I get cranky when sleep deprived.) Less than twenty-four hours earlier, the chairman, Dick Kovacevich, had been talking about an acquisition of potentially $15 to $20 a share with no government support. How could things have changed so dramatically since then? I told them I wanted a firm offer and I wanted it then, or else we would go with a competing bid.

  That competing bid, of course, was from Citi. Consistent with the proposal that the NY Fed had been pushing on Saturday, it submitted a bid of $1 a share, with the FDIC providing protection on a $312 billion pool of high-risk mortgage and commercial real estate assets for losses in excess of $42 billion. In return for providing loss protection, the FDIC would receive $12 billion in preferred stock and warrants. On its face, the latter aspect of the offer looked like a good deal for the FDIC, and if Citi had been a healthy institution, it might have been. But the truth was—as we were only starting to fully appreciate—that Citi was a very sick institution, and it was happy to pay us a generous amount in stock for our assistance because the NY Fed and OCC would let it count that $12 billion as capital, thereby improving its sagging capital ratio. That was unbelievable to me. The main purpose of regulatory capital requirements is to protect the FDIC from losses should an institution fail. But there was no loss protection if we were the ones holding the shares of stock. (We had asked for a commitment from Citi to go to the market to raise $15 billion in real capital issuance, but the Fed and OCC had not supported our request, and Citi had refused.)

  After my conversation with the Wells team, they also came up with a bid that was less favorable to the FDIC under our least-cost test. Under our authorizing statute, we are required to pursue the bid that imposes the least cost on the government, and we have established procedures and methodologies for making the least-cost determination. Wells proposed that the FDIC provide protection on a smaller pool of $127 billion of Wachovia assets. Wells would take the first $2 billion in losses; after that, the FDIC would cover 80 percent of the losses, but our total exposure would be capped at $20 billion. That bid was better from the perspective that Wells was a much healthier and better-managed company and, as a California-based lender, had much more experience than Citi managing mortgage assets on the distressed West Coast. It was also better in protecting our “tail” risk; that is, we knew we would likely have to pay out some amount in loss protection, as losses on that $127 billion portfolio were likely to exceed $2 billion, but we also knew our maximum exposure would be $20 billion. With the Citi deal, we were much less likely to pay anything on the loss protection because Citi would be covering initial losses up to $42 billion, a very high amount. However, if losses turned out to be catastrophic, there was no cap on our exposure, which theoretically could run up to $270 billion. And of course, there was always the risk that Citi itself would run into trouble, even with Wachovia’s stabilizing deposit base. In that case, the whole mess would be back in our arms and that $12 billion in premiums would amount to nothing. Standing alone, Citi’s insured deposits were only about $125 billion. But with that deal, its insured deposits would balloon to nearly $600 billion.

  However, under the rules we follow in determining least cost, we could not take into account the relative health and risks of the acquirer, and both the OCC and the NY Fed had approved Citi as healthy enough to acquire Wachovia. But our examiners did need to evaluate the probability of FDIC losses in both deals to confirm that the projected losses from the Citi deal would be less costly than the Wells proposal. Because of the lateness in being notified of Wachovia’s problems, our examiners were not familiar with the quality of Wachovia’s assets, and it took them some time, working with the OCC examiners, to complete their analysis. They had to rely heavily on the OCC supervisory staff but finally concluded there was minimal likelihood that the losses on the $312 billion pool of assets would exceed $42 billion, and thus Citi should win the bid.

  The other problem we encountered was an accounting one. If our examiners turned out to be wrong and we did end up having to pay out on the Citi deal, our only source of available cash was the Deposit Insurance Fund. But under our statutory scheme, losses associated with systemic risk determinations are supposed to be paid for through a special assessment that falls primarily on large institutions, not the DIF, which is there to protect insured deposits, not bail out big banks. So we asked Treasury if they would be willing to set up a separate line of credit that we could borrow from to make Citi payments, which would be repaid through the special assessment, should the unexpected happen and losses exceeded $42 billion.

  I was trying to avoid the prospect of dipping into our declining reserves to support this bailout package. But we were asking only for a special line of credit, which the FDIC would repay in full. We did not ask Treasury to cover possible losses on the Citi deal.

  In truth, it was the first time the FDIC had completed a transaction under the systemic risk exception, and we received little advance notice or cooperation from other regulators. FDIC staff worked tirelessly all night to work through the analytical, legal, and accounting issues to get the deal done, and instead of being thanked, our efforts were met with snide, off-the-record criticism that Wessel and Sorkin took at face value without contacting us for a response. Ben Bernanke, ever the gentleman, sent an email to me on the morning of Tuesday, September 30, congratulating us on our “extraordinary actions61” on Sunday night and the “ability of your staff to accomplish this in practically no time. I don’t think the markets appreciate the size of the bullet that was dodged—although everyone will understand it when the history is written.” Hope you are right, Ben.

  My board, the Fed, the Treasury, and the White House all approved the Citi deal early Monday morning, and it was announced before the markets opened. Ben Bernanke and Hank Paulson hailed the deal as reinforcing the government’s commitment to financial stability. I thought our work was done; all that was left was approval by the Citi and Wachovia boards. But by Wednesday morning, Citi still hadn’t closed the deal, and in fact, it was renegotiating key provisions of its transaction with Wachovia without even consulting us. Then, on Wednesday afternoon, I received a call from Hank Paulson advising me of a rumor that Wells was going to come back in with an offer to buy Wachovia without government assistance. He called back on Thursday to confirm that Wells was ready to make an offer. I was a bit perplexed that I still had not heard directly from Wells, so I contacted Bob Steel to see if he had heard from Kovacevich. He had not and was getting ready to board a plane, so he asked me to contact Jane Sherburne, Wachovia’s general counsel.

  In
the interim, I received a call from Dick Kovacevich, who finally notified me that Wells was getting ready to make an offer for Wachovia. I couldn’t believe it! After jerking Bob Steel and the Wachovia board around during the weekend, then tormenting us all Sunday night and Monday morning as we waited for them to make a bid, I was concerned that he was just messing around again and wasn’t fully committed to making a serious offer. He somewhat sheepishly told me that Wells had had more time to analyze the risks associated with Wachovia’s loans. He also referenced a recent tax ruling that made the economics of the deal work better. I did not know anything about the tax ruling he was referring to (which later became quite a controversy), but it did not surprise me that he was referring to the tax consequences of the deal. Tax considerations frequently drive merger decisions, whether they are of banks or any other entities.

  He asked me if I had any objection to Wells moving forward. Since Wells was not asking the FDIC for assistance and since Citi had left itself vulnerable by not yet completing its own transaction, I really didn’t have much leverage to object, even had I wanted to (which I didn’t). I did tell him, however, that he should not move forward unless he had a written, irrevocable, firm offer approved by his board. Wachovia was still a highly unstable institution, and it should not move forward unless they were serious and could execute quickly.

  I then called Sherburne, gave her a heads-up about the Wells offer, and reaffirmed, once again, that they shouldn’t even talk to Wells unless it had a firm written offer. I also advised her of the FDIC’s “nonobjection” posture and wished her good luck.

  Later that night, I would receive calls from both Steel and Sherburne, giving me updates on the discussions and seeking my input on what to do in what was clearly a highly unusual and unprecedented situation. I felt that I was walking a fine line. Regardless of my personal views, it was really up to the Wachovia board. Its institution was failing, and one of these transactions had to go through. I told Steel and Sherburne that they needed to act in the interests of their shareholders, but I also stated the obvious: that, at $7 a share, the Wells deal was clearly the better offer.

  Around 5 A.M., Steel and Jane notified me that their board had approved the Wells offer. Steel asked me if I would join him on the call to Citi’s CEO, Vikram Pandit, to deliver the news. I agreed. I didn’t want Citi trying to relitigate Wachovia’s decision with me, so being on the call to make clear we weren’t going to get in the way of this seemed to make sense. Pandit groggily answered the phone, and Steel got straight to the point. The silence was deafening. Talk about a rude awakening! Pandit asked me if I would get off the phone, which I did. I can only imagine the conversation he had with Steel after I hung up.

  Then my phone rang. It was Pandit. He wanted to up the Citi offer to $7 a share, but he wanted the FDIC to continue to support the deal with the loss-sharing arrangement. I told him we had committed to his $1-a-share deal and would stick with that if the Wells deal did not go through. (The Fed still had to approve the Wells acquisition.) But we were not going to subsidize his getting into a bidding war with Wells, particularly since Wells was not seeking government assistance.

  The Wells deal was announced early Friday morning. Over the next several hours there was a flurry of calls and emails that culminated in a very heated exchange on Friday evening among all of the regulators. The Fed wasn’t sure that it wanted to approve the Wells deal. Instead of being pleased that Wells had agreed to buy Wachovia without government help, Tim Geithner was arguing that the Wells acquisition would hurt the credibility of the government in backing transactions. At the behest of the Fed, we issued a statement, also on Friday morning, stating that we would stand behind the original Citi deal if the Wells deal did not go through.

  During the Friday evening call, Tim Geithner was apoplectic. He wanted us to object to the Wells transaction and support Citi in making an enhanced bid of $7.50 a share. That would increase the cost of the transaction for Citi by another $15 billion, which was a huge stretch for it. It was amazing to me that Tim wanted us to take that additional exposure when there was another offer on the table that required no government support. He used that familiar saw: if we didn’t support Citi, it could destabilize the system. I was incredulous. Both offers provided full backing of all depositors and his precious bondholders. Why would they run, knowing that under any scenario, they would be protected? In any event, the Fed, not the FDIC, approved mergers. The transaction was out of our hands. If the Fed wanted to disapprove the Wells offer, we would stand behind the original Citi deal.

  Of course, Tim wanted to use the FDIC as cover for the Fed blocking the transaction. I was not going to let my agency be used. It was clear that the Fed did not have the will on its own to block it, and Fed Vice Chairman Don Kohn supported us in our unwillingness to increase government support just to help Citi. I suggested that the Fed try to broker a compromise between Wells and Citi. What Citi really needed was Wachovia’s stable domestic deposit base. Wells’ interest was in its lending platforms. Perhaps Wells could sell some of Wachovia’s deposit-taking branches to Citi, while keeping the assets. The Fed agreed, and Kevin Warsh was dispatched to try to work it out. The negotiations lasted all weekend, but the gap between the two institutions was just too great to bridge. The Fed approved the Wells deal.

  CHAPTER 9

  Bailing Out the Boneheads

  As we at the FDIC were dealing with WaMu and Wachovia, the Fed and Treasury were dealing with the broader aftermath of the collapse of Lehman Brothers, a $600 billion investment bank, which filed for bankruptcy on September 15, 2008. Lehman’s failure had created major disruptions in the markets and acute liquidity problems, particularly for other investment banks that did not have stable deposits. I believe that stemmed from a combination of factors.

  First, the bankruptcy defied market expectations. Bear Stearns had been bailed out, and most market players assumed that the government would step in with Lehman as well, given that it was a much bigger institution. Markets hate uncertainty, and the Lehman failure confused them. Was the government going to bail everyone out or not?

  Second, Lehman’s balance sheet was nontransparent to the market, primarily because of accounting rules that allowed Lehman to hold complex mortgage-related investments at valuations that really bore no reality to their true worth. Because of that flexible accounting treatment for complex securities, Lehman looked as if it was much stronger than it really was. The lack of transparency about Lehman’s true financial condition immediately created suspicion about other financial institutions that also held opaque, complex mortgage investments on their books. As a consequence, the institutions with the biggest exposures, such as Merrill and Citigroup, started having problems accessing credit even from other financial institutions, as did Morgan Stanley and Goldman Sachs to a lesser extent. (It is always amazing to me that as the major financial institutions started running from one another, retail depositors kept their heads and their money in the FDIC-insured deposits. If they had not, the system really would have fallen apart.) But probably the biggest problem related to a fairly technical provision of bankruptcy law that gave all of Lehman’s derivatives counterparties the right to cancel their contracts and liquidate any collateral Lehman had posted with them. As a consequence, Lehman’s counterparties canceled billions of dollars’ worth of derivatives contacts and dumped the collateral—primarily mortgage-backed securities—onto the market, which put further downward pressure on market valuations of those securities and created even further suspicion about the value of similar securities held on the books of other financial institutions. (As will be discussed later, if there is a single thing Congress could do to make the bankruptcy process work for financial institutions, it would be to eliminate this unusual right of derivatives counterparties to cancel their contracts and liquidate their collateral.)

  In any event, the fallout was severe.

  A large money market mutual fund, the Reserve Primary Fund, which had invested heavily i
n Lehman Brothers, suffered significant losses and had to “break the buck.” This piercing of money market funds’ veneer of safety—one that the industry had fostered to compete with banks for deposits—had the predictable result of leading to widespread withdrawals from money market funds. Money market fund investors were waking up to the reality that their money was not government-insured and that, unlike with FDIC-insured deposits, it was possible that they could lose some of their cash. Hank Paulson and his team made up an emergency guarantee program for those funds that—unlike with insured bank deposits—had no limit on government coverage. I give them credit. They created the program pretty much out of whole cloth (the fund they used, the Exchange Stabilization Fund, was supposed to be used to stabilize the dollar in world trade). Unfortunately, they did not consult with us and did not even consider that the unlimited coverage would create liquidity issues for banks. For weeks, we had been watching runs on uninsured deposits at weaker banks. Now, with a new government program providing money market funds with generous, unlimited guarantees, we were afraid that even the healthy banks would start losing their uninsured deposits, which stood at $2.7 trillion.62

  On September 17, I was in New York on one of our deposit insurance public education tours, scheduled to ring the opening bell at the NYSE and conduct a series of press interviews. Up at six, I made some coffee with the machine in my hotel room and opened the papers that had been delivered to my door. USA Today had a front-page story on Treasury’s plans to announce this unlimited program, probably leaked by the money market fund industry, which had been pushing for it. I hoped against hope that the leaks were not true. If they were, we would soon start hearing the giant sucking sound of uninsured deposits draining out of banks and being deposited in money market funds, which, of course, were sponsored by giant mutual funds and retail brokers such as Merrill Lynch. I called my chief of staff, Jesse Villarreal, who was with me on the trip, to try to verify the validity of the reports before I called Hank to protest. He connected with David Nason, who confirmed that unlimited coverage was the game plan. By seven o’clock, I was on the phone with Hank, still in my PJs. He was annoyed at first but heard me out. I didn’t try to talk him out of the program—clearly something needed to be done—only to place some limits on coverage to keep bank deposits stable as well as to protect the Treasury from unnecessary exposure. He agreed with my suggestion to limit coverage to individual account balances at the close of business that day. So if a money market fund investor had $300,000 on deposit at the close of business on September 17, his insurance coverage would not exceed $300,000. That had the desired effect: it stabilized money market funds without destabilizing bank deposits.