Friday, October 30, 2015

How Bernanke's Encouragment of Bue Sky Thinking Shaped the Fed's Responses in the Financial Crisis

At Bernanke's behest, in response to early tremors foreshadowing the financial crisis, Federal Reserve board members and staff engaged in a process of idea generation and brainstorming. The effort was aimed at finding creative ways to provide emergency short-term lending and guarantee programs to extinguish the potential fires of financial panic and restore collapsed financial markets. 

This blue sky thinking was well underway by September 2007 and prepared the Fed for what Bernanke calls "the dark abyss" at the height of the panic and pushed the limits of the Fed's authority in the bailouts of Bear Stearns and AIG. 

By Robert Stowe England
October 30, 2015

Before former Federal Reserve Chairman Ben Bernanke came up with an array of lending facilities to put out the fires of financial panic that broke out in 2007, he laid the groundwork inside the Fed with a brainstorming effort he called blue sky thinking. “We had ongoing conversations that were like a doctors diagnostic discussion, where you throw out ideas and then try to think about what could go wrong and the advantage and disadvantage of each approach,” says Bernanke at his office at Brookings Institution, where he is a distinguished fellow in residence with the Economic Studies Program.

By summer’s end 2007, after the first tremors of the financial crisis rattled the financial world, creative thinking inside the Fed had already generated a blue sky list of options to fight financial panic, according to Bernanke’s new book The Courage to Act: A Memoir of a Crisis and Its Aftermath, published by W.W. Norton October 5.

Compiling a playbook of short-term emergency lending options to fight panic was an important development at the Fed, according to David Wessel, director of the Hutchins Center on Fiscal and Monetary Policy at Brookings Institution. “It is kind of amazing Bernanke got the job at the time he did” because he brought important insights from his study of the role of monetary policy in the Great Depression, Wessel says. One key lesson: “The arteries of the economy were clogged with the carcasses of dead banks. And, the Fed’s inability to deal with that stopped the economy from recovering,” he says.

Bernanke reports in his book that he laid out his case in support of the policy options on the blue sky list in a September 2, 2007, email to Fed Vice Chairman Don Kohn, New York Fed President Timothy Geithner, and Fed board member Kevin Warsh.

Top of the blue sky list was a proposal to offer foreign currency liquidity swap lines with other central banks to provide dollars to overseas markets with repayment collateralized by the borrowing central bank’s home currency. This idea was soon implemented in December 2007 when the Fed extended swap lines to the European Central Bank and the Swiss National Bank. A proposal to auction interest rates for short-term loans to depository institutions to take away much of the stigma attached to borrowing from the Fed’s discount window became a reality in December 2007 with the creation of the Term Auction Facility.

A third blue sky proposal was to invoke the little-known Section 13(3) of the Federal Reserve Act, which would allow the Fed in “unusual and exigent circumstances” to lend short-term to any creditworthy person or entity, not just depositories, provided there was good collateral to back the loan. When board members who received Bernanke’s email pushed back on this idea, Bernanke resisted and said he would keep it, but as a gesture to those who criticized it, he offered to list it under the “Hail Mary section.”

By March 2008, with fresh crises erupting almost daily, Bernanke decided it was time “to break out the Hail Mary section of the playbook.” With Bear Stearns cash reserves down to $2 billion on Thursday, March 13 from $18 billion only three days earlier, the firm was facing bankruptcy the next day, Friday, March 14, a prospect the promised a wider panic. In response to what was seen as a systemic threat, the Fed’s board agreed to allow the New York Fed to provide a $12.9 billion emergency non-recourse loan to JPMorgan Chase, which was then to be lent to Bear Stearns. The loan was given to keep Bear Stearns afloat over the weekend so that a deal could be hammered out with JPMorgan to acquire the firm.

Two days later on Sunday, March 16, the Fed’s board also approved a second non-recourse loan of $29 billion to facilitate the acquisition. This loan, combined with a $1 billion loan from JPMorgan Chase, allowed the New York Fed to acquire $30 billion in toxic assets and place them in Maiden Lane, a limited liability corporation. The name of the special purpose vehicle came is also the name of the lower Manhattan street that runs along side the back of the New York Fed building. Tom Baxter, general counsel for the New York Fed, has said that the reserve bank wanted to call the special purpose vehicle “Liberty Street,” which is street on the front side of the New York Fed building and also its street address but found that name had already been taken by another entity. So they switched the name to Maiden Lane.

In the case of the $12.9 billion emergency loan to JPMorgan to bolster Bear Stearns, the Fed invoked Section 13(3) for the first time since the Great Depression. “We felt the uncontrolled collapse of Bear Stearns would be very damaging to the broad financial system and the economy,” Bernanke says. Section 13(3) was invoked again for the second $29 billion loan to acquire Bear Stearns’s assets. Blue sky thinking have paved the way as the Fed had already had internal discussions more than half a year earlier about when it should be used. After the two loans were made, former Fed Chairman Paul Volcker slammed the Fed for intervention and accused the central bank of acting on “the very edge of its lawful and implied power.” Bernanke takes some comfort in noting that at least Volcker did not say the Fed had gone over the edge of its authority.

The New York Fed has been made whole for its loans to rescue Bear Stearns and facilitate its sale to JPMorgan Chase. By June 2012 Maiden Lane LLC had fully repaid with interest its $29 billion loan from the New York Fed from the net proceeds of some of its assets. In September 2014 Maiden Lane repaid with interest the $1 billion loan from JPMorgan Chase with the proceeds from sales. The New York Fed receives 100 percent of cash flows from the remaining assets at Maiden Lane.

Within six months of the Bear Stearns rescue, the Fed would face yet another test of the limits to which it could go to extinguish the raging flames of financial panic. During the week of September 15, 2008, Bernanke recalls, the Fed “stared into the abyss of financial collapse in the darkest says of the crisis.” Lehman went bankrupt and American International Group (AIG) was poised to follow closely behind. In a much-derided decision, the Fed decided not to provide emergency short-term funding to Lehman to provide it liquidity until a buyer, possibly the United Kingdom’s Barclays Bank, could be found for its good assets while possibly a consortium of banks would acquire the bad assets and place them in a special purpose vehicle. “Barclays ultimately bought the broker dealer, a small part of the overall firm. They did not make an offer on the overall firm because their regulator told them they couldn’t,” Bernanke says.

As for AIG, the former Fed chairman describes how he  and Treasury Secretary Hank Paulson engaged in agonizing deliberation and consultation with President Bush and Congress over whether to bail out the company out with an $85 billion emergency line of credit. For the Fed, the decision was fraught with risks, according to Bernanke. The company lacked sufficient financial assets to serve as collateral for so large a loan. However, there was sufficient collateral if you included all of AIG assets, including its many insurance subsidiaries and other financial services companies. The risk, however, was that the underlying value of the subsidiaries would plummet if the holding company failed. This amounted to lending against equity and not lending against assets, which would ultimately raise questions about its legality. Despite those concerns, the Fed “saw no alternative” but to go ahead, Bernanke says.

After Paulson and Bernanke consulted with congressional leaders to explain what they thought they had do to, they got a blunt response from Senate Majority Leader Harry Reid, Nevada Democrat. “Mr. Chairman. Mr. Secretary. I thank you for coming here tonight to tell us about this and to answer our questions. It was helpful. You have heard some comments and reactions. But don’t mistake anything anyone has said here as constituting congressional approval of this action. I want to be completely clear. This is your decision and your responsibility,” Reid said, according to Bernanke.

The New York Fed, the regional reserve bank that extended the AIG loan, required AIG to cede control of 79.9 percent the company, a move seen by some critics as a step beyond the edge of the Fed’s authority. While the rescue was helpful, AIG continued to limp along. Ultimately, the Fed had to continue to advance funding to AIG until its lending totaled $182 billion, the largest bailout for a single company during the crisis. Fannie Mae and Freddie Mac together required $187 billion in advances to stabilize them. The New York Fed eventually expanded its ownership stake in AIG to 92 percent of its common shares. When share prices recovered a few years later, the U.S. government gradually sold off its stake, completing the last sale in December 2012. At the end, the full amount of all the cash advances made to AIG was paid back and the government pocketed a $22.7 billion gain.

Even though the Fed’s loans to AIG were repaid, fresh doubts about the AIG bailout surfaced in June 2015, when Judge Thomas Wheeler of the U.S. Court of Federal Claims ruled that the New York Fed had no right to control and run a company that had taken a sizable loan from it. The ruling came in a shareholder lawsuit brought by former AIG chairman Maurice Greenberg, who owned a sizable stake in the company. The Fed in an official statement stated its actions with AIG “legal, proper and effective.”

Mark Calabria, director of financial regulation studies at the Cato Institute, Washington, D.C., takes issue with the Fed’s response to the Judge Wheeler’s finding the Fed had broken the law and had taken actions beyond its authority. “For the Fed to show such little respect for the judicial system I think is troubling,” Calabria says. “Can you imagine Jamie Dimon saying stuff like that? Well I know we’ve been found guilty of this, but whatever.” The judge also ruled that shareholders could not be compensated for their losses because the government’s action was unauthorized.

The Fed’s blue sky thinking would yet serve up more ideas that the Fed successfully used to calm financial markets. In October 2008, the Fed began purchasing commercial paper and, in the process, stabilized the money market fund industry. In November the Fed set up its Term Asset-Backed Securities Loan facility that provide non-recourse loans to help finance new issues of asset-backed securities that are collateralized by student loans, auto loans, credit card loans, and small business loans. This action revived the ABS market, which had collapsed a year earlier.

According to a Fed spokesman, ongoing research about how to respond to potential systemic risk has been institutionalized at the Fed within the Office of Financial Stability Policy and research, which houses 27 economists. Wessel thinks that Fed probably continue to engage in creative thinking, especially about “how do we begin the tighten monetary policy so that it is something approaching normal without freaking out everyone.”

Blue sky thinking could be a beneficial way to go about finding solutions to the fiscal challenges that have divided and gridlocked Washington along party lines, according to Wessel. This is an important challenge that needs to be addressed. He points out that while the deficit has been brought down, the U.S. still has a very high debt-to-GDP level and the nation faces a big debt problem ahead based on aging populations and health care costs. At the same time the economic recovery remains lackluster and subpar and could benefit from fiscal stimulus. “What is the right fiscal policy to do that makes the present better without making the future worse? That’s a really hard question to answer,” says Wessel. It is also a question that could be posed to a group policy experts and policy makers for an intensive exercise in blue sky thinking.

Bernanke agrees with Wessel about the need to think creatively about fiscal policy and contends that for too long the Fed has done all the heavy lifting on policy matters. It is time, he says, for other policy makers in Washington in the Executive Branch and in Congress to work together on fiscal and regulatory ideas that could energize an economy growing too slowly in part because of slow productivity growth that began before the crisis. That would seem to be an extraordinarily daunting challenge. Bernanke agrees. “It’s obviously not an easy proposition.”