“So if we want them (banks) to be a free capitalist company, they have to be able to fail. If we don’t, we might as well treat them as a utility, because that’s what they are.” Ben Bernanke

As part of my defense efforts, I read the transcript (attached below) of Ben Bernanke’s 2009 closed session before the Financial Crisis Inquiry Commission when it was made available to the public in early 2011. I recently completed a re-read of this important document. As Chairman of the Federal Reserve, during the crisis and to this day, he is our top banker and monetary economist. I would encourage you to read his transcript or the excerpts I have provided below. Mr. Bernanke’s statements and opinions to the FCIC that day make clear that the majority report’s lead finding: “We conclude this financial crisis was avoidable”, cannot possibly be true. Is this the reason that the minority members of the FCIC refused to sign this report and issued two of their own instead? Probably.

Commissioner Thompson: “So no calamity of this magnitude occurs without some early signals that something’s wrong…what were the signals? Why did we..and had we acted on them might we have averted the disaster?”

Mr. Bernanke: “Well, I don’t know, I have to think about that.”

I believe Mr. Bernanke’s testimony is very forthcoming and accurate, with the possible exception of his downplaying the role of the Fed’s monetary policy/low interest rates in fueling risk-taking and the housing bubble. Mr. Bernanke makes clear that he and former Federal Reserve Chairman Alan Greenspan are in agreement on two important points: 1) that macroeconomic events beyond any individual person or firms control were the primary cause of the global financial crisis (“A hypothesis I have advocated is called The Global Savings Glut”), and 2) while there were various signs or concerns, the crisis could not have been (and was not) anticipated even by the best economic and banking experts (“I fully admit I did not forecast this crisis”, “I can point to a number of different things various people said, I don’t know of anybody who really anticipated this…”, “I think instead of relying in the future on particularly perspacious financial geniuses who identify problems accurately in advance, I think we just need to have a more systemic government make an attempt to look at the possible problems”, see more statements like these from Mr. Bernanke below). Therefore, if it could not have been anticipated, it could not have been prevented.

Mr. Bernanke also makes clear that this was not a U.S. mortgage or subprime mortgage crisis, but a much larger global economic event. (“It wasn’t subprime mortgage per se. Subprime mortgages were just the trigger that set off a whole bunch of other bombs.”)

Key Excerpts from Chairman of the Federal Reserve Ben Bernanke’s November 17, 2009, Closed Session before the Financial Crisis Inquiry Commission (quotes are from Mr. Bernanke, unless otherwise noted):

“A second hypothesis, which I have advocated….is what’s called the global savings glut. And the idea here basically is that after the Asian crisis in the nineties, many developing emerging-market economies became capital exporters rather than capital importers….All those things created large capital inflows into the Western industrial countries, notably the United States. It’s a common observation in the context of emerging-market financial crises that they’re often preceded by large capital inflows from abroad and that the problem is that the local banking system can’t handle the massive inflow of capital. So by analogy, sort of a similar story may have happened in the United States…”

“The third explanation, which I’m sure you’ll investigate, has to do with monetary policy in 2003, 2004, 2005. Interest rates were down to 1 percent during that period for the reasons having to do with both the slow recovery from the recession and because of concerns about deflation at the time. Some have argued…and I’m sure you’ll look at it…that those low rates contributed to the risk-taking…”

“…Treasury took over Fannie and Freddie. We felt at that point, you know, the implicit guarantee of the government on all of Fannie and Freddie’s MBS and debt was there, and this was so globally held in such large amounts, that the loss of confidence in that would have basically been a huge problem for the stability of the financial system…The Fed was concerned about the GSEs and their capitalization and their financing for a long time. Chairman Greenspan testified about that way back in…you, 15 years. So we were right on that one.”

“When the subprime mortgages began to go bad, a number of us, like myself and Paulson, we’re wrong in saying that it was a contained problem.”

“As a scholar of the Great Depression, I honestly believe that September and October of 2008 was the worst financial crisis in global history, including the great depression. If you look at the firms that came under pressure in that period…only one…was not in serious risk of failure. So out of maybe 13…13 of the most important financial institutions in the United States. 12 were at risk of failure within a period of a week or two…And the fact is that globally, somewhere on the order of 15 to 18 major firms were bailed out, rescued, saved by their governments in Europe and in the UK. So it was very much a global phenomenon.”

Commissioner Holtz-Eakin: “…no one could understand basically the panic in the tri-party repo. That run on the repo market is really what drove the spreading of the crisis. Would anyone have been able to able to anticipate that? You didn’t seem to.”

Mr. Bernanke: “No. So maybe not. Maybe not. I mean, I think a thorough review of the system would have identified this as a critical piece of the infrastructure…But it’s possible that it might not have been identified specifically. But, of course that was then, this is now. We now have the benefit of the crisis. You’re absolutely right, I mean, there is no guarantee that a macroprudential approach will identify every possible crisis.”

“The reform will be a failure if we could not contemplate the failure of Goldman Sachs. That is, there needs to be a system by which Goldman Sachs will go bankrupt and its creditors could lose money. If we don’t have that, then we might as well treat them as a utility, because that’s what they are.”

“So if we want them to be a free capitalist company, they have to be able to fail.”

“I fully admit that I did not forecast this crisis. And in defenses, for what it’s worth, is that again, if you just thought about this as a subprime mortgage crisis…I mean, clearly you want to understand why subprime mortgages did what they did and why they were such a problem and so on. But it wasn’t subprime mortgages per se.  Subprime mortgages were just the trigger that set off a whole bunch of other bombs.”

Vice Chair Thomas: “The perfect storm of all these.”

Mr. Bernanke: “And it’s a perfect storm, is what it was…I would do…a narrative and sort of say, how did these things interact with each other to create the perfect storm…So these connections are very complex, and the only way to do it is to understand the main threads and then try to tell a narrative.”

Vice Chair Thomas: “I find it’s fairly easy after the facts.”

Mr. Bernanke: “Well, after the facts, yes.”

Commissioner Born: “You’ve talked a lot about the need for a systemic risk supervisor and the need to understand the exposures of big institutions and the interconnectedness…I mean, nobody really, totally saw the problems with securitization or OTC derivatives.”

Mr. Bernanke: “Right. So..I actually gave a speech about that. So financial innovation we all thought was great…most people thought it was a great thing…You know there was a lot of people who argued that subprime mortgages were a big innovation, that they allowed people who couldn’t otherwise afford homes, to get homes, and your know it was a wonderful thing. So clearly, you know, people didn’t understand the vulnerability of say, 3/27 ARMs to a downturn in housing prices, for example. So, I guess what I would…this goes back to my answer to Doug, which is that I do not think there is any foolproof way to avoid financial crisis in the future…”

Commissioner Thompson: “So no calamity of this magnitude occurs without some early signals that something’s wrong…what were the signals? Why did we..and had we acted on them might we have averted the disaster?”

Mr. Bernanke: “Well, I don’t know, I have to think about that.”

“I think there were people saying…including people at the Fed…saying, in the year before the crisis, that risk was being underpriced, that spreads were very narrow, that markets seemed ebullient, that liquidity was, in some sense excessive. There were..you know, the way I would put it is, I think there were people…not necessarily the same people…identifying parts of the problem..But I think notwithstanding the claims of one or two people out there who are now sort of making a living on the fact they, quote “anticipated the crisis”, I would still say the interaction of these things, the “perfect storm” aspect was so complicated and large, that I was certainly not aware, for what it’s worth..and it could be just my deficiency…but I was not aware of any kind of comprehensive warning…in this blogosphere we live in now…at any given moment, there are people identifying 19 different problems, crises.”

Vice Chair Thomas: “And they may be right at some point.”

Mr. Bernanke: “And this is the thing, one of them is probably right, but you don’t know who in advance…I would be very skeptical…So people that, quote, identify a problem, but they don’t get the timing or magnitude right. So I welcome your…you know attempts to unravel this…So, while I can point to a number of different thing various people said, I don’t know of anybody who really anticipated this”

Commissioner Thompson: “So there were no actionable signals?”

Mr. Bernanke: “Possibly, yes. So I think rather than saying, you know….obviously some folks are going to come out looking bad or whatever based on what they saw or didn’t see. But I think instead of relying on the future on particularly perspacious financial geniuses who identify these problems accurately in advance, I think we just need to have a more systemic government or whatever structure that will at least make an attempt to look at the possible problems..”

“I think the Fed…the Fed made some mistakes. But I think the current attitude in Congress that somehow the Fed is now the scapegoat, I think that’s quite unfair. The Fed, I don’t think that our interest-rate policy was a big source of the problem…”

Vice Chair Thomas: “One of the main points you mentioned was the global savings glut. I mean, you know, you’re watching the monetary drop, we used to watch our fiscal drop. Now here was this…was somebody accounting for it, somebody examining the profile and sovereign funds and the rest. Was there any real collection of the amount of money coming in, where we were turning little, bitty dials, and there was this hose coming in from the private sectors.”

Mr. Bernanke: “We knew all those numbers, of course. But a lot of smart people….and you asked the question about anticipation, people like Paul Volcker and others thought it was going to cause a crisis. But they got it wrong. They thought it was going to cause a dollar crash. It didn’t do that. It caused a different kind of crisis. Just another example of how difficult it is to predict.”

“Let me make one observation from my own experience, which is one of the things that my historical studies has helped me with this, recognizing that politics is part of the dynamics of a financial crisis. In the 1930s, after the crisis got bad, then they had these Pecora hearings, where they were…J.P. Morgan got…the midget sat on his lap and all kinds of funny things happened. But it’s sort of predictable that there’s going to be a political reaction…But it’s true the politics have been bad…the politics has been so poisonous…”

More Excerpts from Chairman of the Federal Reserve Ben Bernanke’s November 17, 2009, Closed Session before the Financial Crisis Inquiry Commission:

Chair Angelides: “…we wanted to ask you to come by today to give use your perspective on the crisis, the causes.”

Mr. Bernanke: “One general area you’re going to want to look at is the macroeconomic context, the macroeconomic background that led to the risk-taking and so on of the crisis…So why did risk-taking increase? One hypothesis is the so-called great moderation. In a way, this suggests that monetary and fiscal policy were too successful during the eighties and nineties in creating a very stable environment, low inflation. And that it was that sense of excessive security that led to risk-taking. That’s one hypothesis. A second hypothesis, which I have advocated in a number of speeches…is what’s called the global savings glut. And the idea here basically is that after the Asian crisis in the nineties, many developing emerging-market economies became capital exporters rather than capital importers….All those things created large capital inflows into the Western industrial countries, notably the United States. It’s a common observation in the context of emerging-market financial crises that they’re often preceded by large capital inflows from abroad and that the problem is that the local banking system can’t handle the massive inflow of capital. So by analogy, sort of a similar story may have happened in the United States…People…have argued that the emerging markets were looking for high-quality, safe assets, like Treasuries, for example….And that, indeed, once there became a sort of shortage of Treasuries, that there was strong incentives to U.S. financial institutions to create, quote, “safe assets.” And that’s where the securitized AAA credit assets came from. The third explanation, which I’m sure you’ll investigate, has to do with monetary policy in 2003, 2004, 2005. Interest rates were down to 1 percent during that period for the reasons having to do with both the slow recovery from the recession and because of concerns about deflation at the time. Some have argued…and I’m sure you’ll look at it…that those low rates contributed to the risk-taking….I think there are a lot of different components of this issue….if I could just sort of illustrate why there are a number of different questions to be looked at. The first question is, was, in fact, this policy (monetary) the cause or a major cause? And as I have said, there are some alternative hypothesis, like the saving glut and some other things. A second question is, if it was a cause, you know, was it a knowable problem? Was the Fed doing the best it could give the information it had, or was it neglecting information it should have used?…And related to that is the general issue, which has become very hot in monetary circles, which is, should monetary policy be used to try to know down bubbles or not?…Even if you believe that the Fed’s monetary policy was a contributor to the bubbles, it should be noted that even people who are most critical of the Fed’s policy acknowledged that it was only….it was not a large mistake. It was a percentage point or two relative to, say, what the Taylor rule, which is the standard measure of interest rate policy is…if you have a situation where a relatively small mistake…if it was a mistake, I’m just accepting that hypothesis…leads to the biggest financial crisis since World War II, I mean, what does that say? They say that the system itself was inherently unstable and that a relatively small shock was enough to knock it off the pedestal.”

Mr. Bernanke: “A second are, I’ll call the “shadow banking system”. I’m sure you’ll look in detail at housing finance, at the GSEs, at subprime mortgages…The Fed was concerned about the GSEs and their capitalization and their financing for a long time. Chairman Greenspan testified about that way back in…you, 15 years. So we were right on that one.”

Mr. Bernanke: “But, you know, we’ve acknowledged that we didn’t do enough to prevent the subprime lending crisis, in particular, since we had authority to put some rules against some of the practices that occurred. What I’d like to call your attention to is the broader phenomenon of the so-called shadow banking system, which subprime mortgages were only one type of asset which were bundled together into securities, and then these securities were then sold through various legal off-balance sheet type mechanisms to investors, usually with AAA ratings from the credit rating agencies.”

Mr. Bernanke: “When the subprime mortgages began to go bad, a number of us, like myself and Paulson, we’re wrong in saying that this was a contained problem. And the reason we were wrong was that the subprime mortgage themselves were a pretty small asset class. You know, the stock market goes up and down every day more than the entire value of the subprime mortgages in the country. But what created contagion, or one of the things that created contagion, was that subprime mortgages were entangled in these huge securitized pools, so they started to take losses and in some cases, the credit-rating agencies, which had done a bad job basically of rating them began to downgrade them. And once there was fear that these securitized credit instruments were not perfectly safe, then it was just like an old-fashioned bank run…..Of course, again, flaws in the securitization process. I’m sure you’ll want to look at the credit-rating agencies.”

Mr. Bernanke: “A third category of topics has to do with regulation…One is gaps in coverage. AIG is a great example….Another example is the investment banks, which were a huge problem, of course….Number two, I would mention is capital and liquidity. You know, was the Basel framework adequate? I think one of the things that struck me the most about this, though, was liquidity…For example, runs in the tri-party repo market, where what we used to think was very stable funding, which is funding through repurchase agreements where the investment banks would put out, asset overnight and use that as collateral, they thought that was a pretty much foolproof form of short-term funding. But in a crisis where people began to doubt the liquidity or the value of those assets, the haircuts went up and you got into a vicious cycle which led to Bear Stearns collapse and was important in the Lehman collapse as well. And finally…”too big to fail”, you’re going to look at that, I’m sure, in great detail. You know, why did the firms become so big? Why did they become so interconnected?”

Mr. Bernanke: “Another aspect of supervision is the lack of what has become known as “macroprudential” or “systemic” supervision. There was too much focus on individual firms…The Fed is currently revamping its supervision to take into account more macroprudential types of oversight.”

Mr. Bernanke: “I think the issue of the shadow banking system is very important and the role of the maturity transformation, the fact of the use of the short-term financing is something the focus on, say, subprime lending might miss, and I think you need to think about that. And I think that really was a very important element in the crisis, as was liquidity problems associated with…you know, Lehman and Bear Stearns and so on. So those are some things you might otherwise perhaps miss.”

Mr. Bernanke: “What we were seeing at that time was exactly this cycle of worsening haircuts, that is, where the financing…so that Bear Stearns was the weakest of the six or five investment banks. The investment banks relied on this repurchase agreement, overnight tri-party repo financing model. And this is when that model was really beginning to break down. And as the fear increased, the lenders, via the tri-party repo market and other short-term lending markets, again, began to demand larger and larger haircuts, premiums, which was making it more and more difficult for the financial firms to finance themselves and creating more and more liquidity pressure on them. And it was heading sort of to a black hole. Considered at the time of Bear Stearns…was that the collapse of Bear Stearns might bring down the entire repo market, the entire tri-party repo market, which was the source of financing for all the investment banks and many other institutions as well. Because if it collapsed, what would happen would be that the short-term overnight lenders would find themselves in possession of collateral, which they would then try to dump on the market. You would have a big crunch in asset prices. And probably what would have happened would…our fear at least…was the tri-party repo market would have frozen up. That would have led to huge financing problems for other investment banks and other firms; and we might have had a broader financial crisis….And, you know, following the (Bear) rescue, the markets did improve quite a bit. Then we had for a number of months a considerable increased stability in funding markets.”

Mr. Bernanke: “Subsequently, of course we didn’t mention Fannie and Freddie, but Treasury took over Fannie and Freddie. We felt at that point, you know, that the implicit guarantee of the government on all of Fannie and Freddie’s MBS and debt was there, and that this was so globally held in such large amounts, that the loss of confidence in that would have basically been a huge problem for the stability of the financial system.”

Mr. Bernanke: “As a scholar of the Great Depresssion, I honestly believe that September and October of 2008 was the worst financial crisis in global history, including the Great Depression. If you look at the firms that came under pressure in that period…only one…was not in serious risk of failure. So out of maybe 13…13 of the most important financial institutions in the United States. 12 were at risk of failure within a period of a week or two…And the fact is that globally, somewhere in the order of 15 to 18 major firms were bailed out, rescued, saved by their governments in Europe and in the UK. So it was very much a global phenomenon…”

Mr. Bernanke: “We knew…we were very sure that the collapse of Lehman would be catastrophic…It would probably bring the short-term money markets into crisis, which we didn’t fully anticipate; but, of course, in the end it did bring the commercial paper market and the money market mutual funds under pressure…We could not (save it). We did not have the legal authority to save it…Two days later, AIG, again, we felt that its failure would threaten the stability of the global financial system. Among other things, they had as counterparties many of the world’s largest bank financial institutions, many of the world’s largest banks…Now, why AIG and not Lehman?…So we were able to…we made a loan…we didn’t put capital in (to AIG), we made a loan against the assets of the entire company. In the case of Lehman Brothers, there was just a huge hole. I mean, they were insolvent and they had a thirty-to forty billion hole in their capital structure.”

Vice Chair Thomas: “And you wouldn’t have done it, anyway.” (bailing out Lehman’s hole)

Mr. Bernanke: “That’s right. And it would have been a bad decision, anyway because we had so much…so many other firms already on the brink, coming down the pike.”

Mr. Bernanke: “First, is that “viewed too big to fail” is a very, very serious problem, and one that was much bigger than was expected. And I think it’s absolutely critical that if we do only one thing in financial reform, it is to get rid of that problem. It has to be possible for firms to fail. But in the context of the financial crisis last Fall, it was our judgment, which was…in my opinion, was vindicated by subsequent events, that the collapse of one of these firms would have had very serious effects, not only on other financial firms but on the whole economy.”

Mr. Bernanke: “And I would just point out as evidence that prior to Lehman’s failure, the CDS spreads were blowing out, that everybody…every creditor was running to pull their money out of Lehman. The stock prices was plummeting. This doesn’t sound like a situation where people thought that Lehman was going to be protected. There was truly a lot of uncertainty, a lot of fear that Lehman would not be protected. And, in fact, it was that very fear and uncertainty that forced us into the situation in the first place.”

Mr. Bernanke: “…secondly, that I think the events have vindicated the view that, while it was an extraordinarily unpleasant situation and one where we shouldn’t have been in the first place, the failure of those firms, particularly Lehman, created a huge amount of chaos in the financial system which spilled over to a very sharp decline in economic activity around the world.”

Commissioner Holtz-Eakin: “But one of these…I just want to understand this…is that no one could understand basically the panic in the tri-party repo. That the run on the repo market really is what drove the spreading of the crisis. Would anyone have been able to anticipate that? You didn’t see to.”

Mr. Bernanke: “No. So maybe not. Maybe not. I mean, I think a thorough review of the system would have identified this as a critical piece of infrastructure that required careful attention. But it’s possible that it might not have been identified specifically. But, of course, that was then, this is now.”

Commissioner Holtz-Eakin: Right.

Mr. Bernanke: “We now have the benefit of the crisis. You’re absolutely right, I mean, that there’s no guarantee that a macroprudential approach will identify every possible crisis. But clearly, where we can we want to strengthen the system, we want to create as many ways of identifying problems as possible.”

Commissioner Georgiou: “Back in last September, when you created…you began to supervise Goldman Sachs as a single bank holding company at the Fed. Do you regard that as a temporary condition or a permanent one?…How long will they have access to the Fed window and so forth, since it’s an institution that will be regarded as so large to be required to be protected forever?”

Mr. Bernanke: “So first of all, under current law, Goldman Sachs is a bank holding company so under current law, the Fed is the umbrella supervisor of Goldman Sachs….You used the word “protection”. My view is that, going forward, that the firms are systemically critical…and Goldman Sachs is one of them…should, on the one hand, receive tougher, more comprehensive oversight than other firms. Because not only are they…not only do we need to protect them themselves, but because of the damage they would do to the broader system if they collapsed. Morever, tougher, more comprehensive oversight, including higher capital and liquidity requirements and so on makes it less attractive to be big….And there would be and incentive to shrink if, in fact, you could escape some of the intrusive oversight.”

Mr. Bernanke: “The other part, though…and again, I just want to say this as strongly as possible…the reform will be a failure if we could not contemplate the failure of Goldman Sachs. That is, there needs to be a system by which Goldman Sachs will go bankrupt and Goldman Sachs’ creditors could lose money. If we don’t have that, then we might has well treat them as a utility, because that’s what they are.”

Mr. Bernanke: “So if we want them to be a free capitalist company, they have to be able to fail.”

Vice Chair Thomas: “Downsize.”

Mr. Bernanke: “We don’t have….there are many ways to do it. You can downsize them, many things…”

Vice Chair Thomas: “I think one of the things that happened, especially with AIG…and I’m just judging the way people talk to me…they were absolutely shocked when you put money into AIG and it’s like a bucket, and where the money flowed, all these European folks and the rest of it really brought home, I think, for some folks for the first time how interdependent we are.”

Mr. Bernanke: “No, I think Europeans and the British, in particular, are quite taken by the severity of the crisis, and they recognize that some of the problems were homegrown as well as imported from the U.S. I would have to say that, broadly speaking, financial regulation is one of those areas where there’s more international cooperation than in almost any other are of regulation. You know, we regularly go to Basel, they talk of the Basel Capital Committee, and they have many other subcommittees and various other types, and there’s called the Financial Stability Board, which is a body that brings together the regulators and the central bankers around the world. So there’s a lot of standard-setting and rules and so on which are set up on an international basis.”

Mr. Bernanke: “If we can’t do that, then what may happen is that we may go to a world where the large companies are required to separately capitalize their subsidiaries in each country. For example, Citigroup owns Banamex, which is a big Mexican bank. Under the kind of provision I am thinking of, Banamex would have to have its own capital, its own liquidity. And so if there was a failure, Banamex itself could stand on its own and the Mexican government would worry about Banamex, and we would worry about the rest of Citigroup. Now, that would actually greatly simplify the process of bringing down and closing a global company.”

Mr. Bernanke: “The only way, what gave financial products its AAA rating was the full faith and credit, essentially of the whole AIG company. There is no way to say that financial products is bankrupt without bringing down the whole company, and that was the dilemma.”

Mr. Bernanke: “I think, unfortunately for you, it’s the latter.”

Chair Angelides: “The latter being?”

Mr. Bernanke: “The integration, the interaction of all these different factors. So one of the reasons…so, again, I fully admit that I did not forecast this crisis. And in defense, for what it’s worth, is that, again, if you just thought about this as a subprime mortgage crisis…I mean, clearly, you want to understand why subprime mortgages did what they did and why they were such a problem and so on. But it wasn’t subprime mortgages per se. Subprime mortgages were just the trigger that set off a whole bunch of other bombs.”

Vice Chair Thomas: “The perfect storm of all these.”

Mr. Bernanke: “And it’s a perfect storm, is what it was. And then having laid out how each of these areas involved, and what the main forces were, then if were doing it, I would then sort of do a kind of a narrative and sort of say, how did these things interact with each other to create the perfect storm? And I think unless you identify it, there’s no single simple thread, linear thread, that will let you do it….so in our case, what’s the connection between Lehman Brothers and General Motors? Lehman Brothers’ failure meant that commercial paper that they used to finance went bad, which meant that the reserve fund which held the Lehman commercial paper broke the buck, which there was a run in the money market mutual funds, which meant the commercial paper market spiked, which was a problem for General Motors. So these connections are very complex, and the only way to do it is to understand the main threads and then try to tell the narrative.”

Vice Chair Thomas: “I find it’s fairly easy after the facts.”

Mr. Bernanke: “Well, after the facts, yes.”

Chair Angelides: “To what extent do these come together in certain mega-institutions…these threads?”

Mr. Bernanke: “Well, I mean, clearly, the mega-institutions were the focus of the crisis. I mean, that’s not a necessary thing. We’ve had other crises, like the savings and loan.

Chair Angelides: “But in this one.”

Mr. Bernanke: “In this one…I’m saying, but in this one, mega-institutions were, in some sense, the heart of the crisis. And all the things I’m talking about, one way or another impacted on their stability and the stability of the system. So were things like over-the-counter derivatives trading and things of that sort, which reflect interactions between firms. There were some medium-sized firms that were involved, the IndyMacs and the WaMus and things like that. But basically, it was the complexity of large firms. And think of it as…and, again, it was our…but it was part of our problem, that we were looking at this firm (in the Fall of 2008) and saying, “Citigroup is not a very strong firm, but it’s only one firm and the others are okay”, but not recognizing that’s sort of like saying, “Well, four out of your five heart ventricles are fine, and the fifth is lousy”. They’re all interconnected, they all connect to each other; and therefore, the failure of one brings the others down.”

Mr. Bernanke: “So by definition, a systemically critical firm is one whose failure would create broad problems for the financial system and the economy…One would be size and, therefore, the number of counterparties and creditors and so on that it has…Another element with the word that comes up a lot is interconnectedness…Bear Stearns, which is not that big a firm, our view on why it was important to save it…was that because it was so essentially involved in this critical repo financing market, that its failure would have brought down that market, which would have had implications for other firms…Another example is AIG…well, so AIG is big. But I’ll give you a smaller one, like some of these companies that were mortgage insurers, which are pretty small companies. But, you know, their failure required by accounting rules would have forced the markdowns…serious markdowns of many of their counterparties who had use them to insure their mortgage positions, for example. So they were connected to a large number of other firms…so size, inteconnectednes…And then the third would be provision of critical services, like the J.P. Morgan example (co-running the tri-party market)…So companies that either are closely tied to or perform critical market functions, like exchanges or clearinghouses, are also very important. Another criterion that’s been used by some scholars is (market/price) correlation…”

Commissioner Hennessey: “To the extent that there were specific problems over the last couple of years, were they just in CDS…I’m sorry, within those universe of derivatives, was it CDS and asset-backed securities, or were there broader problems or problems with other subsets of the derivative world?”

Mr. Bernanke: “I think the biggest problems were in those two categories you mentioned.”

Vice Chair Thomas: “…why was it (the OTC CDS market) expanding rapidly? Because there was no tent to put it under?”

Mr. Bernanke: “Well, it’s actually a…from a finance theory point of view, it’s actually a very clever instrument.”

Vice Chair Thomas: “Oh, yeah?”

Mr. Bernanke: “What it does, it allows you very cheaply and efficiently to insure yourself against the credit risk of a particular firm or even an index of firms.”

Vice Chair Thomas: “Give me…in theory? In theory or in reality?”

Mr. Bernanke: “Well, in reality, if you use them right…More generally, you know, it’s kind of expensive to buy and sell corporate bonds. You can buy it…it’s much cheaper to buy and sell CDS, which have the same risk…So it’s a very…in principle, it’s a very efficient instrument.”

Vice Chair Thomas: “And, therefore, used by a lot of people very quickly.”

Mr. Bernanke: “Used by people, and grew very, very quickly. And became…frankly, the regulators probably didn’t help here. Because in the sort of capital regulation of banks, to the extent that banks can show that they have hedged their risks, they can hold less capital…the other problem here, besides just the primitiveness of this system in which they cleared and settled, was that the counterparty risk wasn’t taken into account. So people who lost…you know, you could lose money because you took a bad position…but you could also lose money because you made that bet with AIG and they couldn’t pay off.”

Commissioner Born: “…you’ve talked a lot…about the need for a systemic risk supervisor and the need to understand the exposures of big institutions and their interconnectedness…I mean, nobody really, totally saw the problems with securitization or OTC derivatives.”

Mr. Bernanke: “Right. So…I actually gave a speech about that. So financial innovation we all thought was a great thing…or maybe we didn’t think it, but most people thought it was a great thing. But it obviously had a downside, which like any other invention, it can blow up if it hasn’t been safety-tested sufficiently. And that clearly turned out to be an issue in the consumer level, for example. You know, there was a lot of…there are a lot of people who argued that subprime mortgages were a big innovation, that they allowed people who couldn’t otherwise afford homes, to get homes; and, you know, it was a wonderful thing. So clearly, you know, people didn’t understand the vulnerability of, say, 3/27 ARMs to a downturn in house prices, for example. So, I guess what I would…this goes back to my answer to Doug, which is that I do not think there’s any foolproof way to avoid financial crisis in the future, although we could do all we can to make them smaller and less damaging…I don’t want to be too prescriptive here…but where, say, a consumer agency could look at new consumer products and sort of look at them, anyway, where regulators would look at big innovations in types of financial products, financial instruments. And not so much to be…I don’t necessarily mean to say that the regulator would say, “You can’t do this one”…So, yes, I think we need to have a somewhat more balanced view about the effects of financial innovation, that there are times when it can be dangerous. And, again, while, without promising, by any means, that we can identify all the problems, at least some attempt to look at things and road-test them and look at how they interact with other markets and ask some hard questions, would be at least a step in the right direction.”

Commissioner Thompson: “So no calamity of this magnitude occurs without there being some early signals that something’s going wrong. In the case of this calamity, what were the signals? Why did we…and had we acted on them, might we have averted the disaster?”

Mr. Bernanke: “Well, I don’t know, I have to think about that.”

Mr, Bernanke: “I think there were people…there were people saying…including people at the Fed but others as well…saying, in the year before the crisis, that risk was being underpriced, that spreads were very narrow, that markets seemed ebullient, that liquidity was, in some sense, excessive. There were…you know, the way I would put it is, I think there were people…not necessarily the same people…identifying various parts of the problem…But I think notwithstanding the claims of one or two people out there who are not sort of living on the fact that they, quote, “anticipated the crisis”, I would still say that the interaction of these things, the “perfect storm” aspect was so complicated and large, that I was certainly not aware, for what it’s worth…and it could be just my deficiency…but I was not aware of any kind of comprehensive warning……in this blogoshphere we live in now…at any given moment, there are people identifying 19 different problems, crises.”

Vice Chair Thomas: “And they may be right at some point.”

Mr. Bernanke: “And this is the thing, one of them is probably right, but you don’t know who in advance….I would be very skeptical…there are people like…you know, even…take somebody like Robert Shiller who is now pretty famous for identifying the stock market and the house bubbles; right? A great economist. I have great admiration for him. He’s a very serious guy. But he identified the stock market crash when the Dow was at 7,000. So it went a lot further after that. And he was pretty open-minded in 2002, 2003, whether there was a housing bubble or not…So people that, quote, identify a problem, but they don’t get the timing and magnitude right. So I welcome your…you know attempts to unravel this…So while I can point to a number of different things various people said, I don’t know of anybody who really anticipated the…”

Commissioner Thompson: “So there were no actionable signals?”

Mr. Bernanke: “Well, no, I don’t think that’s true. I mean, I think….well, it’s always a question of legal perspective, if you’re trying to figure out intent, and da, da, da, what did you know and when did you know it. It may be that very few people fully appreciated the risks of subprimed lending in 2001 or 2002. If we had been smarter or more systematic, we might have identified them? Possibly, yes. So I think rather than saying, you know…obviously some folks are going to come out looking bad or whatever base on what they saw or didn’t see. But I think instead of relying on the future on particularly perspicacious financial geniuses who identify these problems accurately in advance, I think we just need to have a more systemic government or whatever structure that will at least make an attempt to look at the possible problems and”

Chair Angelides: “So what you said earlier, J.P. Morgan out of 13 was in a different position Was there something that they saw or did that was definitively different in terms of market practices as an institution?”

Mr. Bernanke: “So J.P. Morgan was never under pressure, to my knowledge. Goldman Sachs, I would say also protected themselves quite well on the whole. They had a lot of capital, a lot of liquidity. But being in the investment banking category rather than the commercial banking category, when the huge funding crisis hit all he investment banks, even Goldman Sachs, we thought there was a real chance that they would go under.”

Commissioner Holtz-Eakin: “I want to ask…sort of just address this narrative, the Fed/Treasury policy and these actions that made this worse. And I think you know this story: Rates too low for too long, creating a housing bubble, failure for supervision oversights, standards on mortgage origination, misdiagnosing counterparty risk, lack of transparency and liquidity problems, the notion that post-Lehman credits were in fact tightening, markets recovering, and the TARP requests comes, and then things explode. How do you respond to that?”

Vice Chair Thomas: “Just a conspiracy ball of wax.”

Mr. Bernanke: “I think the Fed…the Fed made some mistakes. But I think the current attitude in Congress that somehow the Fed is now the scapegoat, I think that’s quite unfair. The Fed, I don’t think that our interest-rate policy was a big source of the problem, both because I don’t think it was obviously the wrong policy, and also because, again, as I said, if the system hadn’t been incredibly fragile, you know, it wouldn’t have caused anything. We are, to some extent, culpable for not doing the subprime mortgage regulation. Supervisions: We did a relatively good job on supervision. If you look at the companies that failed…”

Mr. Bernanke: “I know there are people, probably even on this commission, who believe that Lehman could have been allowed to fail without…or Bear Stearns…without real consequences. I don’t believe that myself. I base it on historical knowledge, and I base it on our detailed analysis of the individual markets and interactions…Looking at AIG, I thought myself…and I believe now…that if we let it fail, that the probability was 80 percent that we would have a second depression. Suppose it was 5 percent…How much would you pay to avert a 5 percent chance of a second depression? $5 billion? That’s probably what we will end up paying. So I think that those are the right decisions to make, and we did the best we could given the limited powers we had.”

Mr. Bernanke: “So a mixed record, but I think we played important roles in saving the situation. And I hope we’ll play an important role in trying to get an improvement in our structure so that in the future we won’t have a problem.”

Vice Chair Thomas: “One of the main points you mentioned was the global savings plan (Bernanke’s term was Global Savings Glut). I mean, you know, you’re watching your monetary drop, we used to watch our fiscal drop. Now, here was this…somebody was accounting for it, somebody was examining the profile and sovereign funds and the rest. Was there any real collection of the amount of money coming in, where we were turning little, bitty dials, and there was a hose coming in from the private sectors…”

Mr. Bernanke: “We knew all those numbers, of course. But a lot of smart people…and you asked the question about anticipation, people like Paul Volcker and others thought it was going to cause a crisis. But they got it wrong. They thought it was going to cause a dollar crash. It didn’t do that. It caused a different kind of crisis. Just another example of how difficult it is to predict.”

Commissioner Georgiou: “The dollar crash is just slower…”

Mr. Bernanke: “Well, it hasn’t happened yet, but it didn’t happen in the early part of this decade….Which is what Volcker at one point said there was a 75 percent chance of a dollar crash within two years, whatever. So he’s been proven wrong on that.”

Vice Chair Thomas: “But that was the dials that he had, in the structure that he was looking at.”

Mr. Bernanke: “But essentially right. The example I would give, would have been the silo mentality of the regulators, that I’m looking at this company, I don’t care about the counterparties, I don’t care about the markets they’re involved in. I’m not thinking about…there’s a difference between…if there’s a common exposure across the whole system and that goes bad, that has a much different implication than if it’s an uncorrelated risk across the system. But for an individual regulator looking at one company, they don’t distinguish between those two, but it’s a critical distinction. That’s why you need some kind of interaction among the regulators.”

Vice Chair Thomas: “Or a bigger, comprehensive, more-umbrella regulatory structure.”

Mr. Bernanke: “Right…well, macroprudential….So I would prefer having a systemic risk council which is responsible for the overall system and looks for emerging risks ad coordinates and shares information, et cetera. But underneath that, you’ve got specialists.”

Mr. Bernanke: “So, of course, and again this is where the Fed and the communication has failed, is that the public still thinks that “Wall Street” was bailed out. We weren’t bailed out.” The reason we bailed out Wall Street….I hate that terminology…but the reason we did it was to avoid a collapse of the broad system, and so on. So the critical thing…the first important achievement was to prevent the meltdown of the global financial system, which we did, in the fall and early into this year. Given that we did that and the financial markets are improving, the credit situation is, broadly speaking, is improving slowly. It’s still tough. It’s better, certainly, for larger firms than it is for smaller firms.”

Mr. Bernanke: “But let me make one observation from my own experience, which is one of the things that my historical studies has helped me with this, recognize the politics is part of the dynamics of a financial crisis. In the 1930s, after the crisis got bad, then they had these Pecora hearings, where they were…J.P. Morgan got…the midget sat on his lap and all kinds of funny things happened. But it’s sort of predictable that there’s going to be a political reaction. And Sheila Bair said yesterday that she thought that TARP was a mistake completely because of the bad politics that have come from it. I don’t think that’s true because the alternative would have been to let the system collapse, which is not what we wanted to do. But it’s true that the politics have been bad…Unfortunately, the politics has been so poisonous….you know, both at the congressional level but also at the local level, where people have accused bankers of taking TARP money, all kinds of horrible things…that the general response of bankers has been to give the money back as fast as they can; or if they have to keep it for some reason, not to base any lending on it.”

Mr. Bernanke: “But I will say that there are other things, like the Fed’s TALF program…actually, in my defense, I should have mentioned a lot of other things we did to protect the asset-backed securities market, the commercial paper market, money market mutual funds, et cetera, et cetera, and our monetary policy…And the unique aspect of this crisis, which was the capital injections, did stabilize the system. And now, a great, good sign is that banks are raising large amounts of private capital and paying back the government capital. That’s a good sign.”

Attachment:


United States of America, Financial Crisis Inquiry Commission
Closed Session
Ben Bernanke, Chairman of the Federal Reserve
November 17, 2009

Posted on September 25, 2013, in Postings. Bookmark the permalink. Leave a comment.

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