by Sheila Bair
We were succeeding in the House in closing off the bailout loopholes in the bill and securing authority for a resolution fund. Chairman Dodd’s staff was also157 coming our way on how resolution authority should be structured, much to the consternation of Tim and Michael Barr. But Frank was sticking158 with the Fed in having a very weak council, with most of the new regulatory authority over systemic institutions going to the Fed. Frank’s Democratic committee members were still nervous about GOP attacks that the new resolution authority was bailout authority. In point of fact, over Treasury’s objections, the Frank staff had included our language expressly prohibiting bailouts. All failing institutions would have to be put into resolution. Frank asked me to meet with his committee Democrats on Saturday, November 7, at 2 P.M., after the president’s scheduled remarks to the Democratic Caucus. I readily agreed.
Paul Nash accompanied me to the meeting. It was held in the committee’s cavernous wood-paneled hearing room. More than thirty members, plus their staffs, were sitting in their tiered seats waiting for a briefing from Frank on the status of the financial reform bill. After providing his members with an update, Frank turned to me and asked me to talk about the new resolution authority. Although I had testified in the room many times, Barney asked me to address the committee from the chairman’s seat atop the dais. Having him turn over the meeting to me in that way underscored that we shared the same priorities in truly ending bailouts. Barney and his staff had accepted our amendments that closed off the loopholes Treasury and others were pursuing. That gave me the ability to assure the committee that the bill banned future bailouts of failing institutions. I walked them through the resolution tools we used at the FDIC to impose losses on shareholders and creditors. I complimented them on their courage in authorizing the resolution fund. I knew that the Treasury Department, under Tim and Michael Barr’s direction, had been working behind the scenes to kill it, but I put my credibility on the line to convince them that Barney had the right approach.
Frank’s committee convened to consider the bill and on December 2, 2009, approved it on a party-line vote of 31 to 27. I was very disappointed that the bill did not attract GOP support, as I believe that with our strengthening amendments, it gave regulators the tools to end too big to fail. The legislation was then sent to the full House, where it was combined with other reform measures previously approved by the committee, including bills to create a new consumer bureau for financial products, provide for regulation of so-called over-the-counter (OTC) derivatives (those not traded on regulated exchanges), and ban abusive mortgage-lending practices.
Our language on resolution authority enjoyed widespread support among House Democrats. Unfortunately, there was continuing controversy over the new consumer protection agency—which we also strongly supported—even within the Democratic Party. Most damaging was an amendment to reinstate the OCC’s power to block states from enforcing their consumer laws against national banks. On Tuesday, December 8, I was having my monthly luncheon with FDIC economists when I received a call from Chairman Frank asking me to contact certain centrist Democrats and Republicans to oppose the amendment. I obliged but wondered why the Treasury Department wasn’t doing it; overturning the OCC’s preemption of state consumer laws, I thought, was an administration priority. In any event, I was happy to help and made the calls.
The full House passed the bill on December 11 by a narrow vote of 223 to 202, again along party lines. The final version included a $150 billion resolution fund, to be assessed against hedge funds with greater than $10 billion in assets and other nonbank financial firms with assets greater than $50 billion. All of our antibailout language was included. We were even successful in securing an amendment offered by Congressmen Bradley Miller (D–N.C.) and Dennis Moore (D–Kans.) to impose losses on secured creditors that had extended short-term credit based on complex, hard-to-value assets as collateral. The purpose of the amendment was to discourage the precrisis practice of poorly managed firms such as Bear, Lehman, and Citi funding their operations with short-term loans and posting toxic mortgage securities as collateral. Creditors who extended credit on those terms would be at risk if the institution failed. Here again, the Treasury Department under Tim’s direction vigorously (but unsuccessfully) opposed this amendment.
Shortly before the final vote in the House, I received an irate call159 from Tim saying that the resolution authority was a “mess” and that the “whole thing” needed to be fixed in the Senate.
Yes, from Tim’s perspective, it was a “mess” because it didn’t permit endless bailouts at his discretion.
After getting that call, I knew we were winning.
But I also knew we would have a real fight on our hands in the Senate, squeezed between the industry and its Senate allies on the one side and the Treasury Department on the other.
CHAPTER 18
It’s All About the Compensation
As we pressed our case in Congress for legislation to permanently ban future bailouts, we struggled with other regulators over how to unwind the 2008 bailouts.
In the summer of 2009, the Fed, as the holding company supervisor, permitted nine members of the $100 billion club to repay their TARP capital investments. We did not object to the repayments. The nine banks had all passed the stress tests and, with the exception of Morgan Stanley, were in relatively strong condition. Morgan Stanley was still wobbly, but it had successfully issued a significant amount of new common equity before it exited TARP, suggesting that there was some market confidence in its financial strength. In addition, it had the deep pockets of the Japanese banking giant Mitsubishi standing behind it.
However, the eight institutions that showed an additional capital need under the stress tests, including Citi, were not allowed to exit. In October, Tim began convening meetings on how the rest of the TARP bailout recipients could exit the program, a surprising reversal of the TARP bailout support he had generously promised to any institution over $100 billion a few months earlier. He asked the Fed, in consultation with us and the OCC, to devise criteria for the standards to be used to approve TARP repayments by the weaker banks before the end of the year.
That was a serious matter for the FDIC. At the Fed and Treasury’s strong urging, we had taken significant exposure in guaranteeing the debt of the giant holding companies, but it had been part of a coordinated action that relied on continued support from both the Fed and the Treasury to protect us against losses. If the weak banks repaid their TARP money without raising significant new capital to replace it, it would leave them in a weakened condition. The banks had originally been required to keep their TARP money for three years, but earlier in the year, the industry, working with the Treasury Department, had convinced Congress to pass legislation allowing them to repay sooner. But when launching TLGP, we had agreed to a three-year debt guarantee, so we would continue to be exposed long after the Treasury got out.
On the other hand, I had acquired a deep dislike for the capital investment program. It was enormously controversial, and as a capitalist, I just didn’t like the idea of the government owning banks, even as a preferred-equity owner. The new resolution framework we were pushing on the Hill would ban government capital investments. Moreover, if the banks were required to replace their government capital with new, privately held common equity, it would strengthen their capital position and, at the same time, reduce the government’s involvement.
But could some of the weak banks raise that much common equity? The Fed thought that requiring them to raise one dollar of new common equity for every repaid TARP dollar was too harsh. Instead, its staff circulated a proposal to require “1 for 2,” meaning that a bank would have to issue one dollar of new common equity for every two dollars it repaid in TARP. So, for instance, Bank of America, which had received $45 billion in TARP capital, would need to issue $22.5 billion in new common equity.
Given the major capital raises that many of the banks had already completed over the summer after the stress tests, we
were comfortable with the 1-for-2 construct for all of them, except Citi. Citi had been required to raise only $5.5 billion after the stress test. As previously discussed, we viewed this as a “lowball” number that had helped Citi keep its tax benefits. We insisted that Citi’s TARP repayment had to be at least dollar for dollar. Citi had already been given a special break when the Treasury had converted $25 billion of its original $45 billion of TARP into common equity, planning to sell those shares off to private investors. Citi would never have to pay back that $25 billion. As a consequence, even with a 1-for-1 standard, Citi would have to raise only $20 billion to repay the remaining $20 billion in TARP funds. It needed every penny of that capital.
We also insisted that the capital increase be done with common equity newly issued to the open market. That was the only way we could be sure that the TARP exit process actually strengthened the banks. We didn’t want to see gimmicks such as issuing stock as additional compensation to employees or measures that could actually weaken the banks, such as selling good, income-producing assets. We wanted full market validation of each bank’s strength by requiring that it convince private investors to commit substantial amounts of new capital to it.
The Fed purported to agree with us on those points, and on November 3, it finalized its guidance along these lines. However, while giving us verbal assurance that they would require at least 1-for-1 repayment of Citi, the Fed dropped a footnote we had asked for saying that some banks would be required to repay on a dollar-for-dollar basis. It did, however, agree to consult with us and the OCC before approving any individual bank’s TARP repayment plan.
I thought we had a solid agreement with the Fed and Treasury, one that was motivated by a desire to help the government start exiting the bailout programs but in a way that would ensure a stable financial system. Looking back, I see that I was naive. I think what was really going on was that Citi and BofA—the two biggest bailout recipients—were desperate to get out of the special restrictions on executive compensation that had been placed on them when they received their second round of TARP money.
Indeed, within just a few weeks of issuing the guidance, the Fed and OCC were pushing us to loosen its parameters. BofA had proposed a repayment plan that was laughably short of the principles in the guidance. Its original proposal would have raised only $9.25 billion in common equity, with another $4 billion in trust-preferred securities, which are essentially a form of debt. We pushed back hard, demanding the full $22.5 billion. After several more proposals, BofA proposed raising $14 billion in new common equity, $3.5 billion in trust preferred, $8.8 billion in assets sales, and $1.7 billion in employee stock compensation.
At that point, the Fed notified us that it wanted to give BofA flexibility to conduct assets sales as part of the capital raise, in direct contravention of our agreement. Again we demanded a full $22.5 billion in newly issued common equity. We presented an analysis that had been prepared by our outside investment adviser, Perella Weinberg Partners, that a capital raise in excess of $20 billion was achievable, though the shares would have to be sold at a steep discount. That, I suspected, was the real reason BofA did not want to go to the market with a huge capital raise; it did not want to dilute current shareholders’ assets. On November 21, I circulated the analysis to my colleagues, stating that dilution of shareholders’ assets should not be our concern. Our job was to ensure the safety and soundness of the institution. The Fed and OCC dug in. The Fed insisted that BofA could not sell that amount of common equity and that a failed offering would undermine confidence in the institution. I replied that if it couldn’t complete an offering of that size, it wasn’t strong enough to exit TARP.
I also cautioned against the precedent the Fed would set if it gave BofA that flexibility. In an email to Don Kohn and Dan Tarullo, I wrote, “Acceptance of this . . . proposal will have repercussions beyond [Bank of America]—as other banks see that the [government] has loosened its repayment standards and will expect to get a similar deal.” I went on to conclude, “None of us liked the TARP program, but let’s not compound the error now by allowing a weak institution to prematurely exit.”
But my arguments fell on deaf ears. The Fed let it be known that it was prepared to go ahead and approve the repayment plan over our objection.
Upon hearing that from my staff, I responded that we would need to notify the bank directly that we objected to its plan, a communication that BofA would likely have to disclose to investors under securities rules. Fortunately, the Fed did not force our hand and continued discussions with us.
I then made a counterproposal: that BofA raise $15 billion to partially redeem $30 billion of its TARP investment and that Treasury give it some flexibility under its compensation restrictions, solely for the purpose of recruiting a new CEO. BofA’s longtime CEO, Ken Lewis, had been forced out of his position, and the BofA board was having a hard time finding a strong replacement. Obviously, it was in the FDIC’s interest for BofA to bring in a well-qualified CEO, and we were willing to support flexibility on pay and bonus restrictions solely for that purpose.
We and the Fed reached agreement on this counterproposal. When the Fed presented the plan to BofA, the bank flatly rejected it. But instead of telling BofA it was that or nothing, the Fed came back to us to negotiate some more! I later discovered that the Fed had also been consulting with Lee Sachs at the Treasury Department, Tim’s close advisor, who was disdainful of our concerns and siding with the bank. I still refused to give.
Fortunately, Fed Vice Chairman Don Kohn started to question BofA’s analysis and pushed the bank harder to explain why it couldn’t do the full $22.5 billion. On November 25, two of BofA’s board members came to see me to plead their case. Again, I told them we needed the full $22.5 billion in common equity. On December 1, BofA came in with its tenth repayment plan, which had it issuing $18.8 billion in common stock and $4 billion in trust preferred, which we again rejected.
Its last and final offer was to raise the remaining $4 billion in asset sales. We agreed to that on the condition that BofA fully exercise what is called a “green shoe” up to $3.5 billion. What that meant was that if it had investors willing to buy more than the $18.8 billion offered, it had to sell them additional shares up to $3.5 billion. I received verbal assurance from both the acting CEO and the chairman of the board that they would exercise the green shoe, and we notified the other regulators that this was key to our agreement. Based on Perella Weinberg’s analysis, I was confident that BofA would have sufficient investor demand to raise the full $22.5 billion.
I was right. Demand for the offering was far in excess of the $18.8 billion. BofA easily sold the $18.8 billion and could have sold $3.5 billion more. But in violation of its commitment, it sold only an additional $500 million of the green shoe. I do not believe that BofA would have defied us if we had had the other regulators’ support. However, the Fed and OCC already had egg on their faces, given the ease with which BofA raised so much new capital. Making BofA go all the way to $22.5 billion would have fully vindicated us, and the OCC and Fed were not going to let that happen.
As I predicted, giving BofA flexibility on the 1 for 2 encouraged other banks to seek similar flexibility. We had to fend off similar attempts by Wells Fargo and PNC to raise substantially less than the 1 for 2. But, as usual, the biggest fight was yet to come from Citigroup.
Our examiners felt that Citi actually needed to raise more than $20 billion to exit the program. They put the number at closer to $35 billion. The Fed eventually settled on $25 billion, but there again, as was the case with BofA, the Fed was willing to be flexible as to how the capital was raised. But the real agenda with regard to Citi’s repayment did not become known to me until the night of December 3, 2009. At Paul Volcker’s invitation, I attended a dinner meeting of a prestigious international banking group known as the G30. The dinner was being held at the NY Fed building. Bill Dudley was also at the dinner, and at its conclusion, he asked me to meet with him privately in his office (n
ot the anteroom, but of course, he wanted something from me). We settled into his paper-cluttered office, and he got right to the point. Citi wanted to get rid of its $300 billion ring fence so that it could be free of all government support and the compensation restrictions that went with it. The NY Fed wanted to let it do so.
I rolled my eyes in disbelief. Citi’s bungling management had just finished identifying the assets that were going into the ring fence a few weeks earlier. Yes, it had taken them nearly a year to decide which toxic assets they wanted to ring fence. Now they wanted to get rid of the ring fence? I had heard through the grapevine that Vikram was telling stock analysts that Citi was going to repay its TARP money and exit the ring fence so that it would have flexibility to pay bonuses to keep employees. He was also boasting that at some point it would start paying dividends again. We had laughed those stories off as delusional. Later, I found out that Citi had been having discussions with the NY Fed about terminating the ring fence going back to September.
I had underestimated the NY Fed’s and Treasury’s determination to make Citi look healthier than it was. They wanted to bolster its ability to compete against the better-managed banks. I essentially told Bill that was a nonstarter. Again, our outside financial adviser Perella Weinberg thought that the market liked the ring fence. The market knew how sick the bank was. Exiting all the government programs would not make Citi look stronger; no one would buy that. It could, however, weaken the markets’ perceptions of the institution by eliminating all of its government support. I hated the bailouts and I hated the TARP capital investments, but we had gone down that path and the FDIC had guaranteed a significant amount of Citi’s debt—at the Fed’s and Treasury’s urging—to keep it from failing. Now the Treasury and Fed were happy to pull out while leaving us exposed with the debt guarantees. And if Citi got sick again, there was no going back, because TARP was ending.
