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October 1, 2010
Via Email & Mail
Phil Angelides
Chairmall
Hon. Bill Thomas
Vice Chairmall
The Honorable Ben S. Bernanke
c/o Mr. Dave Caperton
Special Counsel
Board of Governors of the Federal Reserve System
20th Street and Constitution Avenue, N.W.
Washington, D.C. 20551
Dave.Caperton@frb.gov
Brooksley Born
Commissioner
Byron S. Georgiou
Re:
Financial Crisis Inquiry Commission Hearing on September 2,2010
Commissioller
Dear Chairman Bernanke:
Senator Bob Graham
Commissioller
Keith Hennessey
Commissioner
Thank you for testifying on September 2, 2010 in front of the Financial Crisis
Inquiry Commission and agreeing to provide additional assistance. Toward that
end, please provide written responses to the following additional questions and
any additional information by October 15,2010. 1
Douglas Holtz-Eakin
Comm issioner
Heather H. Murren, CFA
Commi sioner
John W. Thompson
Commissioner
1. Please provide information regarding Wachovia' s use of Federal Reserve
lending facilities during the run on the bank.
2. Please provide the Federal Reserve's solvency calculation for Wachovia
on September 26, 2010.
3. Please provide any information about Lehman's financial condition or its
collateral in the weeks leading up to the company's bankruptcy.
Peter]. Wallison
Commissioner
I The answers you provide to the questions in this letter are a continuation of your testimony and
under the same oath you took before testitying on September 2, 20 I O. Further, please be advised
that according to section 100 I of Title 18 of the United States Code, "Whoever, in any matter
within the jurisdiction of any department or agency often United States knowingly and willfully
falsifies, conceals or covers up by any trick, scheme, or device a material fact, or makes any false,
fictitious or fraudulent statements or representations, or makes or uses any false writing or
document knowing the same to contain any false, fictitious or fraudulent statement or entry, shall
be fined under this title or imprisoned not more than five years, or both."
1717 Pennsylvania Avenue, NW, Suite 800 • Washington, DC 20006-4614
Wendy Edelberg
Executive Director
202.292.2799 • 202.632.1604 Fax
Chainnan Ben Bernanke
October 1, 2010
Page 2 of2
4. During your testimony, you stated the Federal Reserve Bank of New York conducted a
collateral analysis of Lehman Brothers, upon which you relied to make your decision not
to use the Federal Reserve's Section 13(3) authority. Please provide the collateral
analysis, the name of the person who communicated the collateral analysis to you, and
the time and location when you were infonned of the collateral analysis. Please infonn
the Commission of the name or names of persons who conducted the collateral analysis
for the Federal Reserve Bank of New York. In addition, please provide a list of persons
with whom you or your staff consulted with regards to this matter in the White House or
the Treasury and any related memoranda, documents, emails, etc.
5. Please report the dollar value of the shortfall of Lehman's collateral relative to the
collateral necessary to issue a bridge loan or other secured assistance to Lehman on
September 14,2008.
6. Please provide a recommended reading list for the Commission.
The FCI C appreciates your cooperation in providing the infonnation requested. Please do not
hesitate to contact Sarah Knaus at (202) 292-1394 or sknaus@fcic.gov if you have any questions
or concerns.
Sincerely,
Wendy Edelberg
Executive Director, Financial Crisis Inquiry Commission
cc:
Phil Angelides, Chainnan, Financial Crisis Inquiry Commission
Bill Thomas, Vice Chairman, Financial Crisis Inquiry Commission
BOARD OF GOVERNORS
OF THE
FEDERAL RESERVE SYSTEM
WASHINGTON, D. L
20551
November 4, 2010
SEN 5, 8ERNANKE
CHA!RMAN
Mr. Philip Angelides, Chairman
Mr. William Thomas, Vice Chairman
Financial Crisis Inquiry Commission
1717 Pennsylvania Avenue, N.W., Suite 800
Washington, D.C. 20006
Dear Chairman Angelides and Vice Chairman Thomas:
Thank you for inviting me to appear before the Financial Crisis Inquiry
Commission on September 2,2010, to discuss my thoughts on the causes of the financial
crisis and respond to your questions. This letter responds to the supplemental questions
you sent me on October I, 2010 and provides additional information regarding the issues
you raised in your letter inviting me to testify before the Commission. To most
effectively and efficiently respond to the questions posed in your two letters, my
responses are organized by topic.
Supervision
You asked generally (1) how the Federal Reserve supervised large financial
institutions prior to the financial crisis, (2) whether that method of supervision has
changed since the crisis, and (3) about lessons learned from the crisis regarding the
supervision of large financial institutions.
1. Supervision Prior to the Financial Crisis
The Federal Reserve used and continues to use a risk-focused approach to
supervision of the largest banking organizations (and other banking organizations),
focusing on identifying the areas of greatest potential risk to a banking organization and
assessing the ability of its management to identify, measure, monitor, and control these
risks. Special attention in the examination process is focused on risk management
systems and internal controls used by core clearing and settlement organizations and
organizations with significant presence in key financial markets, in light of the potential
for adverse impacts from these areas to transmit across the banking and financial system.
Federal Reserve staff develops an understanding of supervised institutions
through regular monitoring of the activities of the firms and through examinations and
other reviews designed to identify and become knowledgeable about specific business
practices and assess these and their associated risk management and control practices
against supervisory expectations. The largest firms are subject to continuous supervision
and each has a dedicated team onsite at the firm full time. For each institution, the
Federal Reserve focuses on: understanding the key elements of the banking
organization's strategy, primary sources of revenue, risk drivers, business lines, legal
structure, governance and internal control framework, and presence in key financial
markets; and assessing (i) the effectiveness of risk management systems and controls
over the primary risks inherent in the organization's activities, (ii) the organization's
financial condition, and (iii) the potential negative impact of nonbank operations on
affiliated depository institutions. l
The Federal Reserve's Bank Holding Company Rating System (RFI) relies upon
assessments of risk that are both static and forward looking and considers implications
for both capital and liquidity when assessing overall safety and soundness. The RFI
rating system serves as a useful vehicle for identifYing problems, including increasing
risks at BHCs, and evaluating overall safety and soundness trends. Under RFI, each
BHC is assigned a composite rating (C) based on an overall evaluation as well as an
assessment of future potential risks. The main components of the RFI rating system
represent: Risk Management (R); Financial Condition (F); and Impact (I) of nondepository entities on subsidiary depository institutions. The F component further relies
on four subcomponents reflecting assessments of the quality of capital; asset quality;
earnings; and liquidity.
Regulators endeavor to ensure that supervisory attention is appropriately focused
on potential financial and operational weaknesses or adverse trends. An important part of
this is robust evaluation of an institution's capital planning process. An effective capital
planning process2 requires banking organizations to assess the risks to which they are
exposed and to review their processes for managing and mitigating those risks.
All banks and bank holding companies (BHCs) regulated by the Federal Reserve
are required to meet minimum regulatory capital requirements. However, institutions are
generally expected to operate with capital levels well above regulatory minimums and in
all cases to hold capital commensurate with the magnitude and nature of risks to which
they are exposed. 3 Even in cases where an institution is deemed "well capitalized" or
"adequately capitalized" under Prompt Corrective Action standards,4 the federal banking
agencies have the authority to require it to achieve and maintain ratios (e.g. tier 1
leverage and risk-based capital) in excess of those used to define capital categories. 5 The
I For additional discussion of this topic, see S.R. 08-09, "Consolidated Supervision of Bank Holding
Companies and the Combined u.s. Operations ofForeign Banking Organizations"
2 See SR 09-04, Revised March 27, 2009 for further discussion of this topic
3 See. e.g., 12 CFR parts 208 and 225, Appendix A
4 Banking organizations that do not meet the minimum risk-based standard, or that are otherwise
considered to be inadequately capitalized, are expected to develop and implement plans acceptable to the
Federal Reserve for achieving adequate levels of capital within a reasonable period oftime (12 CFR part
225, Appendix A)
5 Under Board regulations, a state member bank is "adequately capitalized" if regulatory capital ratios meet
the regulatory minimums, typically a four percent tier 1 leverage ratio, four percent tier I risk-based capital
ratio, and eight percent total capital ratio (12 CFR 208.43(b)(2». "Well capitalized" banks must have at
least a five percent tier 1 leverage ratio, six percent tier 1 risk-based capital ratio, and ten percent total risk-
2
Bank Holding Company Act and the Board's Regulation Y also materially limit BHC
engagement in certain risky activities, such as private equity and real estate investments.
While each BHC is responsible for assessing the level of capital appropriate for
its specific risk profile, Federal Reserve guidance describes how supervisory staff
evaluates large or complex banking organizations' internal capital management
processes, judging whether they meaningfully tie the identification, monitoring, and
evaluation of risk to the determination of the institution's capital and liquidity needs. 6
Regulators may require improvement if they determine that an institution's level of
capital or liquidity does not fully support its risk profile? Similarly, under the advanced
approaches risk-based capital rule (Basel II), an assessment of overall capital adequacy is
required. In making this assessment, regulatory agencies consider whether institutions
have a rigorous process for assessing overall capital adequacy in relation to risk profiles.
They also consider whether a comprehensive strategy for maintaining appropriate capital
levels (internal capital adequacy assessment process- ICAAP) exists, and whether
institutions maintain a satisfactory risk management and control structure. 8
In conducting capital planning reviews, examiners are expected to determine
whether the existing capital level is adequate for the BHC's risk profile, following
consideration of the following items: the level and trend of adversely classified assets;
the adequacy of the allowance for loan and lease losses; the volume of charged offloans
and recoveries; the balance sheet structure and liquidity needs; the level and type of
concentrations; compliance with state and federal capital requirements; and composition
of elements of capital. Examiners are also expected to determine whether earnings
enable the BHC to fund growth, remain competitive in the marketplace, and support its
overall risk profile. And examiners are expected to determine the effect of current capital
levels on the future viability of the BHC and its subsidiary depository institutions by
assessing management's ability to reverse deteriorating trends and augment capital
through earnings or by raising additional capital.
2. Changes to Supervision Methodologies since the Crisis
Within the context of continuous supervision and a risk-focused approach, the
Federal Reserve has made a number of changes to the supervision of the largest BHCs,
including with respect to the structure and oversight of Federal Reserve supervision as
well as specific processes designed to enhance forward-looking risk identification and the
execution of supervisory activities. Importantly, the Federal Reserve is making changes
in the direction of supervision of large financial institutions designed to more consistently
and fully draw from our broad range of expertise. The oversight and direction of Federal
Reserve supervision of the largest firms is now more centralized and multidisciplinary. A
newly-formed group of senior officials from the Board and the Reserve Banks -- bringing
based capital ratio, unless subject to written agreement, order, capital directive or other prompt corrective
action directive to meet and maintain specific capital levels (12 CFR 208.43(b)(1 )).
6 See Board SR letter 99-18 (July I, 1999), available at http://fedweb.frb.gov/fedweblbsr/srltrs/SR9918.htm
7 12 U.S.C. §3907 (a) (2).
8 12 CFR Part 567
3
together the Federal Reserve's analytical expertise in macro-economics and finance, in
the operation of money and capital markets, as well as in banking supervision and
regulation -- is responsible for defining supervisory priorities and coordinating
supervisory strategy and plans for large financial firms.
The Federal Reserve is also adopting a more macro-prudential perspective to
complement the traditional focus on individual firm safety and soundness. This includes
heightened focus on the evaluation oflinkages across firms and markets and other
mechanisms that have the potential to amplify both booms and busts, and is supported by
an enhanced surveillance and analysis process for large BHCs, including the
incorporation of information from a "quantitative surveillance" program, which uses
statistical and economic analysis to evaluate the performance of institutions relative to
their peers, to complement the work of our examiners in the field. The Federal Reserve's
enhanced surveillance combines data from research on the macro-economy and financial
markets with firm-specific supervisory information to provide a more comprehensive
understanding of the financial conditions of firms and the risks they face, as well as the
potential for broader impacts on the financial system.
Building off of the Supervisory Capital Assessment Program (SCAP), the Federal
Reserve will conduct periodic supervisory stress tests and scenario analyses across the
largest firms to identify the potential impact of possible adverse changes in the economy
and financial markets. These efforts will be coordinated with and include participation of
other federal banking regulatory agencies, where applicable, and will serve a number of
purposes, including identifying firm-specific and financial system vulnerabilities and
developing horizontal perspectives on key risk exposures and risk-management
challenges across the industry that can be used to inform requirements for corrective
actions where weaknesses exist.
3. Lessons Learned
The changes we have incorporated into the supervision process, described above,
are largely based on lessons leamed during the financial crisis. Some of the key lessons
learned include the following:
We learned that the supervisory processes for identifying key risks and other areas
of potential concern did not keep up with the rapid innovations taking place in financial
markets and products. There was an inadequate understanding of the linkages between
firms and the changing risk profiles of the largest firms stemming from the growth and
evolution of the capital markets. For example, supervisors, as well as senior management
and boards of directors at large financial institutions, did not adequately understand the
risks stemming from the growing use of off-balance sheet entities, particularly the
increased use of bank-sponsored or supported short-term money market vehicles to fund
senior tranches of asset securitizations and re-securitizations. Risk exposures that were
thought to have been widely dispersed across the financial system through the
distribution of credit assets in fact were concentrated in the banking system, largely as a
result of banks' direct, indirect, or implicit support for the underlying securities and
4
funding vehicles. The result was that financial institutions of all types were more
vulnerable to rapid erosion in market liquidity than was recognized.
We learned that supervisors did not insist on sufficiently strong risk management
practices and did not send forceful enough messages to financial institutions requiring
firms to address known deficiencies in an expeditious manner. For example, there was
too little attention paid by supervisors, managers, and boards of directors to rapidly
correcting known weaknesses in some fundamental risk-management practices,
including, but not limited to, those related to emerging and complex business activities.
In an apparently benign environment, there was not a full appreciation of the growing
vulnerabilities created by the increasing speed at which shocks could be transmitted
across the financial system and supervisors, as well as bank managers and their boards of
directors, did not see the urgency of addressing what appeared to be risk management
weaknesses that could be adequately corrected over time.
We learned that, in a period of strong operating performance for financial
institutions and apparently sound economic and financial market conditions, neither
supervisors nor bank managers gave sufficient priority to the identification of low
probability events with potentially highly adverse outcomes or to mitigating actions that
could be taken before such events occurred.
And we learned that firms and risky practices migrated to gaps in the statutory
framework for supervision and, at least for a period of time leading up to the crisis,
market discipline did little to constrain excessive risk taking at financial institutions.
Monetary Policy
You asked how the Federal Reserve views the role of monetary policy in
identifying and managing asset bubbles.
The Federal Reserve conducts monetary policy to foster its statutory objectives of
maximnm employment and stable prices. Consistent with these objectives, the Federal
Reserve adjusts the stance of policy over time based on the outlook for economic activity
and inflation and the risks surrounding that outlook. The economic outlook, in tum, is
importantly influenced by financial variables that affect private spending, such as interest
rates and levels of asset prices. As a result, asset prices and financial market conditions
more broadly are a critical element in monetary policy deliberations. In this framework,
so-called asset bubbles, or other situations in which asset valuations may appear to be
high relative to levels that would be suggested by economic fundamentals, do affect the
stance of monetary policy through their effects on the economic outlook. For example, if
a rapid and substantial rise in equity prices boosts household net worth and trims business
capital costs, this would be expected to lead to a pickup in aggregate spending. The
Federal Reserve might then choose to firm the stance of policy if the projected path of
spending was seen as likely to result in a pickUp in inflation pressures, given the
anticipated productive capacity of the economy.
5
Whether the stance of monetary policy should respond to asset prices beyond the
adjustment called for by their effect on the central bank's outlook for economic growth
and inflation is a long-standing policy debate. Some have argued that a more aggressive
approach -- "leaning against" asset bubbles -- would help to damp emerging imbalances
in the financial system that could contribute to subsequent financial instability with
adverse consequences for the real economy. Others have noted that identifying asset
bubbles in real time is very difficult and, even if they could be identified, calibrating the
appropriate monetary policy response is extraordinarily challenging given our limited
understanding of the factors influencing bubbles. Moreover, monetary policy is a very
blunt tool to apply in response to such problems. For example, tightening monetary
policy in response to a period of easy finance and overbuilding in the commercial real
estate sector in some regions ofthe country could result in higher national unemployment
and weaker economic growth for the economy as a whole. In such cases, supervisory
responses may provide a better-targeted response. For example, supervisors could take
steps to ensure that lenders have appropriate systems in place to measure and manage the
risks associated with such lending, and also that lenders have sufficient capital to handle
the resulting exposures.
The Federal Reserve is putting in place enhanced processes to incorporate a
macro- prudential approach in its supervisory activities-that is, an approach that takes
account of risks to the financial system overall as well as at the level of the individual
firm. The Financial Stability Oversight Council established by the Dodd-Frank Wall
Street Reform and Consumer Protection Act will be a key institutional mechanism at the
national level that, among other things, will focus on identifYing potential systemic risks
and developing appropriate policy responses. Although macro-prudential regulation
should be the first line of defense against the buildup of bubbles or other financial
imbalances, monetary policymakers should be cognizant of possible developing
problems; toward that end, we have significantly stepped-up our efforts to ensure that the
Federal Open Market committee, which sets monetary policy, is well-informed about
current issues related to financial stability and potential systemic risks.
Emergency Assistance
You asked about the Federal Reserve's authority to provide government
assistance under section 13(3) of the Federal Reserve Act and the FDIC's authority to
provide assistance under the systemic risk exception to the Federal Deposit Insurance
Corporation Improvement Act of 1991 (FDICIA) and specifically about the assistance
provided in 2008 using section 13(3) authority. You also asked why the Federal Reserve
recommended that the FDIC provide assistance to Wachovia under the systemic risk
exception of FDICIA and whether the Federal Reserve encouraged the FDIC to accept
Citigroup's assisted bid, rather than Wells Fargo's assisted bid.
1. Emergency Assistance in General
Section 13(3) of the Federal Reserve Act, as in force during the financial crisis,
authorized the Board to make secured loans to individuals, partnerships, and corporations
6
in "unusual and exigent circumstances" and when the borrower is "unable to secure
adequate credit accommodations from other banking institutions." This authority was
granted by Congress during the Great Depression, when a lack of credit availability
severely undermined the economy and contributed to the very low output and very high
unemployment witnessed at that time. This provision was enacted precisely to allow the
Federal Reserve to provide liquidity to individuals and nonbanking entities to relieve
financial pressures that might otherwise have severe adverse economic effects. This type
of lending authority is shared by other central banks worldwide. Prior to the recent
financial crisis, the Federal Reserve had not lent funds under section 13(3) since the
1930s and had only authorized the use of this authority during two brief periods during
the late 1960s in connection with liquidity pressures at thrift institutions, which did not
have access to discount window credit at that time.
Section 13(3) contains a number of important restrictions. In particular, section
13(3) requires that: (1) the Board find that unusual and exigent circumstances exist; (2)
the loan be authorized by the affirmative vote of not less than five Board members
(unless there are fewer than five Board members in office at the time, or in situations
where a financial emergency requires immediate action before five Board members can
be contacted); (3) the loan be secured to the satisfaction of the lending Reserve Bank; (4)
the Reserve Bank obtain evidence that the borrower is unable to obtain adequate credit
accommodations from other banking institutions; and (5) the rate of interest on the loan
established by the Reserve Bank be reviewed and determined by the Board. The DoddFrank Act established a number of new limitations on section 13(3) lending. Perhaps
most importantly, as a result of the amendments in the Dodd-Frank Act, this authority can
only be used to provide liquidity in the form of a program or facility with broad-based
eligibility; the provision of emergency credit to a single or specific company is no longer
authorized under section 13(3). Moreover, any program or facility with broad-based
eligibility that is established under this authority must be approved by the Secretary of the
Treasury.
In general, the FDIC is required to resolve failing or failed insured depository
institutions at least cost to the deposit insurance fund. The "least cost" test is focused on
the direct costs to the FDIC of resolving a particular institution and does not consider
spillover effects that a failure might have for other institutions or markets and the
economy. The Federal Deposit Insurance Act provides an exception to the least cost
requirement-a so-called systemic risk exception-if a least-cost resolution "would have
serious adverse effects on economic conditions or financial stability" and if a non-least
cost resolution method would "avoid or mitigate such adverse effects." Invoking the
systemic risk exception requires written recommendations, by two-thirds votes, of the
FDIC's Board of Directors and the Board of Governors of the Federal Reserve System,
and a decision by the Secretary of the Treasury in consultation with the President. Under
the provisions of the Dodd-Frank Act, the systemic risk exception has been further
limited and now may only be invoked with respect to an insured depository institution for
which the FDIC has been appointed receiver, thereby prohibiting any "open bank"
assistance. The Dodd-Frank Act also restricts support provided under the systemic risk
7
exception to the winding up of an insured depository institution for which the FDIC has
been appointed receiver.
In general, in providing credit under section 13(3) or in recommending the
invocation of the systemic risk exception during 2008 before the enactment of the DoddFrank Act, the Federal Reserve considered the severity of the financial strains and the
potential consequences for the U.S. financial system and economy if support was not
provided. These jUdgments were based on an assessment of the size, activities, and
interconnectedness ofthe affected firms and the importance ofthe financial markets that
were under stress. In addition, the Federal Reserve considered the extent to which the
provision of support to the affected firms or markets could ameliorate the adverse effects
on the broader financial system and the economy that would otherwise occur.
During the financial crisis, the Federal Reserve provided two basic types of
liquidity support under section 13(3)-broad-based credit programs aimed at addressing
strains affecting groups of financial institutions or key financial markets, and credit
directed to particular systemically-important institutions in order to avoid a disorderly
failure ofthose institutions. In both cases the purpose of the credit was to mitigate
possible adverse effects on the broader financial sector and the economy. Liquidity
facilities ofthe first type included the Primary Dealer Credit Facility (PDCF), the Term
Securities Lending Facility (TSLF), the Asset-Backed Commercial Paper Money Market
Mutual Fund Liquidity Facility (AMLF), the Commercial Paper Funding Facility (CPFF),
the Money Market Investors Funding Facility (MMIFF), and the Term Asset-Backed
Securities Loan Facility (TALF). Liquidity support provided to particular institutions to
avert a disorderly failure included credit provided through Maiden Lane LLC to facilitate
the acquisition of Bear Stearns by J.P. Morgan Chase, and credit provided to American
International Group (AIG) through a revolving credit line and through Maiden Lane II
LLC and Maiden Lane III LLC. The Federal Reserve, acting with the U.S. Treasury and
FDIC, also agreed to provide loss protection and liquidity support to Citigroup and Bank
of America on designated pools of assets utilizing authority provided under section 13(3),
but ultimately did not extend any credit to either of these institutions. 9
The fundamental rationale for implementing the range of broad-based credit
facilities was to address the intense liquidity pressures faced by many institutions and the
seizing up of key financial markets at the time, and so to mitigate the adverse effects that
the strains on institutions and markets could have had on the broader economy. The
PDCF and TSLF provided liquidity support to primary dealers that, in tum, were active
participants and market-makers in a range of key financial markets. The AMLF, CPFF,
and MMIFF were established to address pressures associated with the runs on money
market mutual funds in the fall of2008 and the associated strains in short-term funding
markets, particularly the commercial paper market. The TALF was established to
address a shut-down in securitization markets and the associated disruptions in credit
flows to households and businesses. On the whole, these lending programs were
designed to provide credit support to the operation of financial firms and markets during
The arrangements with Bank of America and Citigroup were never invoked and have since been
cancelled.
9
8
a period of extraordinary stress, and thereby helped to foster improved credit conditions
for businesses and households.
The rationale for providing credit support to particular institutions was to avert a
disorderly failure of these institutions and so to limit the impact of the firms' difficulties
on the functioning of financial markets and the broader economy. As we saw following
the failure of Lehman Brothers, the collapse of a large, complex, and interconnected
financial firm can have very substantial effects on other firms and on the functioning of
financial markets.
In all of its actions based on section 13(3) lending authority, the Federal Reserve
was focused on addressing the severe strains evident across a broad range of financial
markets and the associated disruption in credit flows to households and businesses and on
limiting the risks of a further deterioration in financial and economic conditions. A
central feature of the financial crisis was the potential for adverse feedback loops in
which the liquidity strains experienced by markets and institutions led to sharply
constrained access to credit for households and businesses that, in turn, led to weaker
economic activity and the amplification ofthe liquidity strains for markets and
institutions. These adverse dynamics were a major source of systemic risk during the
financial crisis. By providing liquidity support to key financial markets and institutions,
the Federal Reserve's actions helped to short circuit these sorts of adverse dynamics and
to avoid an even more intense financial crisis and economic downturn.
The Federal Reserve has long been committed to the principles of transparency
and public accountability. Consistent with these principles, the Federal Reserve has
provided a great deal of information to the public regarding its balance sheet and the
actions it has taken based on its section 13(3) lending authority. The Federal Reserve
publishes its balance sheet on a weekly basis in the Board's H.4.1 statistical release,
which is also available on the Board's public website. In addition, the Federal Reserve
developed a monthly report to the Congress that provides detailed information on all of
its credit and liquidity programs. Under the Dodd-Frank legislation, the Federal Reserve
will disclose by December of this year individual transaction data for the section 13(3)
programs listed above as well as for the Term Auction Facility (authorized under section
10 of the Federal Reserve Act) and transactions completed before enactment of the DoddFrank Act under the agency MBS purchase program (authorized under section 14 of the
Federal Reserve Act). Moreover, the Federal Reserve is currently working closely with
the Govemment Accountability Office in its review of all of the Federal Reserve's
section 13(3) lending programs.
2. Wachovia
In the fall of 2008, the Board believed that a full or partial default by Wachovia
Corporation (Wachovia) and its subsidiaries on their debt would intensify liquidity
pressures on other U.S. banking organizations. At the time, U.S. banking organizations
were extremely vulnerable to a loss of confidence by wholesale and retail suppliers of
funds. Markets were already under considerable strain at that time because of the weak
9
economy and the events involving Lehman Brothers, AIG, and Washington Mutual Bank
(WAMU) earlier that month. Banking organizations were experiencing mounting losses
on their residential mortgage portfolios and the broader public was becoming concerned
. about the outlook for a number of U.S. banking organizations, moving deposits, putting
downward pressure on their stock prices and putting upward pressure on their credit
default swap spreads.
Wachovia had been experiencing drains on its liquidity during the days leading up
to September 26, 2008. On September 26, 2008, the day after the failure of WAMU,
Wachovia experienced heavy demands for withdrawal of deposits, a key source of funds.
Wachovia management and the supervisors were concerned that, if the loss of deposits
continued, and losses on its mortgage portfolio continued to mount, Wachovia would
become insolvent within a short period. Consequently, Wachovia and the supervisors
sought a private sector solution for Wachovia. JO
On Monday, September 29, 2008, the FDIC armounced that it had facilitated the
acquisition ofWachovia by Citigroup in a transaction in which Citigroup and the FDIC
would share losses on a pool of$312 billion (or nearly 50 percent) ofWachovia's assets.
On the day before, when the Board considered whether the systemic risk exception
should be invoked, only two firms were willing to consider assisting in the resolution of
Wachovia-Citigroup and Wells Fargo-and both firms informed the FDIC they would
bid for Wachovia only if the FDIC provided material loss protection. The FDIC could
provide the loss protection sought by these firms only under the systemic risk exception.
The failure of Wachovia would have led the public to doubt the financial strength
of other organizations that were seen as similarly situated. This could have made it less
likely that they would be able to retain deposits, and raise capital and other funding. In
addition, if a least-cost resolution did not support foreign depositors, the resolution would
have endangered what was a significant source of funding for several other major U.S.
financial institutions as well as Wachovia.
Creditors would also be concerned about direct exposures of other financial firms
to Wachovia or Wachovia Bank, N.A. (Wachovia Bank) since these firms would face
losses in the event of a default. In particular, losses on Wachovia and Wachovia Bank
debt could lead more money market mutual funds to "break the buck," accelerating runs
on these and other money funds. The resulting liquidations of fund assets along with the
further loss of confidence in financial institutions could lead short-term funding markets
to virtually shut down; these markets were already under extreme pressure in the fall of
2008.
JO Wachovia borrowed $5 billion from the Term Auction Facility (TAF) on September 25,2008 (and had
borrowed from the TAF on other occasions). The next day, it began discussions witb Citigroup and Wells
Fargo with the intent of effecting a merger and finding a permanent solution to its potential liquidity issues.
Wachovia did not borrow from the discount window (other than the TAF borrowing just mentioned) until
October 6, 2008, many days after the acquisition ofWachovia by Wells Fargo was announced.
10
The consequences of the insolvency and unwinding ofWachovia under the leastcost resolution test would also have disastrous effects for an already weakened economy.
Business and household confidence would be undermined by the worsening financial
market turmoil, and banking organizations would be less willing to lend due to their
increased funding costs and decreased liquidity. These effects could contribute to
materially weaker economic performance, higher unemployment, and reduced wealth.
For these reasons, the Board by unanimous vote determined that compliance by
the FDIC with the least-cost requirement of the Federal Deposit Insurance Act (FDI Act)
with respect to Wachovia Bank and its insured depository institution affiliates would
have serious adverse effects on economic conditions and financial stability, and that
action or assistance by the FDIC permitted under the systemic risk exception within the
Act would avoid or mitigate these adverse effects by facilitating the sale and private
support of Wachovia. Similar determinations were made by the board of directors of the
FDIC and the Secretary of the Treasury, in consultation with the President, which
allowed the FDIC to consider measures outside the least-cost resolution requirement to
resolve Wachovia, including the provision of so-called "open bank" assistance.
Ultimately, as you know, Wachovia was resolved without any FDIC assistance under the
systemic risk exception.
The Board's determination that a least cost resolution ofWachovia would have
serious adverse effects on economic conditions and financial stability was based on the
consequences of the insolvency and unwinding of that institution, and neutral as to
whether the acquirer was Citigroup or Wells Fargo. While Citigroup was negotiating the
final terms of its proposal to acquire Wachovia, Wells Fargo submitted a second bid to
the FDIC that did not involve FDIC assistance. The FDIC immediately announced that it
would consider and review the new Wells Fargo bid, at the same time reaffirming its
support for the Citigroup bid already accepted by the FDIC. The Federal Reserve also
promptly issued a statement noting that both this second proposal and the Citigroup
proposal were under its review. After Citigroup announced that it was no longer seeking
to enjoin Wells Fargo's acquisition ofWachovia, the Board approved Wells Fargo's
acquisition ofWachovia under the Bank Holding Company Act.
Lehman Brothers Bankruptcy
Your supplemental questions ask about the financial condition of Lehman
Brothers in the weeks leading up to its filing for bankruptcy and how that information
was communicated to me.
The Federal Reserve did not regulate or supervise Lehman. Following the
creation of the Primary Dealer Credit Facility ("PDCF") Federal Reserve examiners did
collect financial information from the primary dealers, and two examiners were assigned
to Lehman. The examiners' responsibility was limited; their purpose was to ensure that
Federal Reserve lending to primary dealers under the PDCF facility would be secured to
our satisfaction, and that the primary dealers continued to seek liquidity sources from the
market.
11
The contention that the Federal Reserve believed it had viable options to rescue
Lehman, but chose not to use them, is simply untrue. As I explained in my oral
testimony, during Lehman Weekend, both the Board and the Federal Reserve Bank of
New York were focused on finding a way to prevent the disorderly collapse of Lehman.
With the support of the Treasury Department and the SEC, we assembled a number of
private sector participants to seek a merger partner for Lehman and a private sector
source of funding for Lehman's troubled assets in order to facilitate a merger. Over that
weekend, when issues arose with Barclays' bid to acquire Lehman, we worked with
Barclays and the UK FSA to try to resolve those issues. However, when Barclays
ultimately indicated that it could not complete an acquisition of Lehman, no potential
merger partner remained.
Without a merger partner, the Federal Reserve saw no viable options for avoiding
a Lehman bankruptcy. Lehman was in immediate need of substantial capital and
liquidity to fund its operations as counterparties pulled funding away or sought better
lending terms and more collateral. Although we did not have precise information about
their credit needs at the time, the balance sheet of Lehman readily illustrated that the
credit relied on by Lehman to remain in operation was in the hundreds of billions of
dollars and the lack of confidence that led counterparties to pull away from Lehman
suggested that Lehman would need a credit backstop of all its obligations in order to
prevent a debilitating run by its counterparties. Moreover, the value of a substantial
portion of assets held by Lehman, especially its investments in RMBS, loans, and real
estate, was falling significantly. Derivative positions were subject to continuing
collateral calls that required amounts of Lehman funding that could not easily be
quantified in advance. And clearing parties were demanding collateral as a condition for
serving as an intermediary in transactions with Lehman. We saw no evidence that
Lehman had sufficient collateral to support these types and amounts of taxpayer support
from the Federal Reserve.
In addition, it did not appear that a loan from the Federal Reserve would be
sufficient, by itself, to prevent the failure of Lehman. Rather, given the market's loss of
confidence in Lehman, liquidity from the Federal Reserve would simply have allowed
Lehman's counterparties to continue to demand and receive repayment from Lehman,
reinforcing the advantage of running on Lehman and increasing exposure to the Federal
Reserve had it lent. Moreover, without a potential buyer for Lehman, the Federal
Reserve could not be certain how long it would be required to fund Lehman or what the
ultimate source of repayment, if any, would have been.
This information was conveyed to me by phone that weekend by FRBNY
officials. As you know, Lehman's primary dealer did have sufficient collateral to support
a limited loan through the PDCF and other existing FRBNY liquidity facilities, and that
credit was provided.
Lehman's own analysis at the time is consistent with this view. By Sunday of
Lehman Weekend, Lehman's board of directors recognized that Lehman was either
12
already insolvent or would imminently be insolvent. I I Moreover, our concerns appear to
be borne out by the bankruptcy proceeding. After extensive analysis, the Lehman
Bankruptcy Examiner, Mr. Anton Valukas, determined that there is sufficient evidence to
show that Lehman Brothers Holding Inc. ("LBHI") was insolvent as of September 8,
2008, and perhaps was insolvent as early as September 2, 2008. 12 Furthermore, the
recent report of the managers of the Estate ofLBHI strongly suggests that a decision by
the Federal Reserve to fund Lehman in September 2008 would have resulted in
substantial losses to the Federal Reserve and taxpayers. On September 22, 2010, Alvarez
and Marsal, representing the LBHI Estate, estimated that the value of assets currently
available to LBHI-which would have been the debtor in a hypothetical loan from the
Federal Reserve-was approximately $57.5 billion as of June 30,2010. 13 Importantly,
these assets are currently all that is available to fund what the Estate estimates to be
approximately $365 billion in likely allowed claims still pending against the Estate-that
is, claims representing roughly 6 times the value of the assets available. 14 Alvarez and
Marsal also estimate that most of these likely allowed claims--between $250 and $350
billion--represent unsecured claims outstanding against the estate--between 4 and 6 times
the value of assets available. IS Thus, even if the Federal Reserve had been able to fund
Lehman to the extent of its available unencumbered assets, this volume of unsecured
claims and total claims illustrate that Lehman's collateral available to secure such a loan
would likely have been insufficient and that Federal Reserve funding would likely not
have been fully repaid.
These facts distinguish Lehman in a number of critical ways from the AIG. In
contrast to Lehman, the core operations of AIG were viable and profitable insurance
companies. AIG's financial difficulties stemmed primarily from the loss of liquidity to
fund collateral calls on its unhedged derivatives positions in one part of the company-its
Financial Products Division. AlG's problems appeared at the time to be more classical
liquidity needs that were quantifiable in amounts and could be covered with borrowings
secured by valuable available collateral-the shares of stock of profitable insurance
companies and other businesses.
The Federal Reserve strongly encouraged Lehman to address its problems
throughout the spring and summer of 2008. When market pressures threatened the
collapse of Lehman, the Federal Reserve made strong efforts, and included a broad range
of other agencies and financial firms, to find a solution that would prevent the failure of
Lehman. At all times and using the limited statutory tools available to it, the Federal
Reserve attempted to balance the costs to the economy with the principle of ensuring that
Il
See Minutes of the Board of Directors of Lehman Brothers Holdings Inc., September 14,2008.
12
Report of Anton R. Valukas, Lehman Brothers Examiner, pp. 1573.
13
See Alvarez and Marsal, p. 18 (September 22, 20 I 0).
14 The total amount of claims filed against the estate exceed $1.2 trillion. The reduced amount of $365
billion represents the result of negotiations and determinations by the bankruptcy estate and court that have
reduced the total claims. The Federal Reserve would not be in the same position as a bankruptcy court or
debtor-in-bankruptcy to negotiate or terminate claims in the event that the Federal Reserve had funded
Lehman's operations and no alternative solution could be found. See Alvarez and Marsal, p. 23 (September
22,2010).
15 See Alvarez and Marsal, p. 6 (September 22, 20 I 0).
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any credit extended by the Federal Reserve would be adequately secured and repaid.
While all decisions are subject to further analysis in hindsight, in the case ofLehrnan, the
facts conveyed to me by the FRBNY at the time and as they have been developed by the
bankruptcy proceeding for Lehman confirm that the Federal Reserve chose the course of
action consistent with its limited statutory authority and the interest of ensuring that any
taxpayer funds lent would be repaid in full.
Reading List
You asked that I provide you with a reading list. Allow me to suggest the
following articles, speeches, and books:
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"The Panic of 1907: Lessons Learned from the Market's Perfect Storm" by Robert F.
Bruner and Sean D. Carr;
"The Ascent of Money: A Financial History of the World" by Niall Ferguson;
"Deciphering the Liquidity and Credit Crunch 2007-2008" by Markus K. Brunnermeier
"CoVaR" by Tobias Adrian and Markus K. Brunnermeier, available at:
http://www.princeton.edul-markus/researchipapers/CoVaR.pdf;
"Lords of Finance" by Liaquat Aharned;
Gary B. Gorton (2008), "The Panic of 2007," paper presented at "Maintaining Stability in
a Changing Financial System," a symposium sponsored by the Federal Reserve Bank of
Kansas City, held in Jackson Hole, Wyo., August 21-23; the paper is available at
www.kansascityfed.org/publicationslresearchlescp/escp-2008.cfm;
Markus Brunnermeier and Lasse Heje Pedersen (2009), "Market Liquidity and Funding
Liquidity," Review a/Financial Studies, vol. 27 (6), pp. 2201-38;
Jane Dokko, Brian Doyle, Michael T. Kiley, Jinill Kim, Shane Sherlund, Jae Sim, and
Skander Van den Heuvel (2009), "Monetary Policy and the Housing Bubble," Finance
and Economics Discussion Series 2009-49 (Washington: Board of Governors of the
Federal Reserve System, December), available at
www.federalreserve.gov/PUBS/FEDS/2009/200949;
Edward 1. Glaeser, Stuart S. Rosenthal, and William C. Strange (2010) "Can Cheap
Credit Explain the Housing Boom?" working paper (Cambridge, Mass.: Harvard
University, July);
Charles Bean, Matthias Paustian, Adrian Penalver, and Tim Taylor (2010), "Monetary
Policy after the Fall," paper presented at a symposium sponsored by the Federal Reserve
Bank of Kansas City, held in Jackson Hole, Wyo., August 28;
Coval, Joshua, Jakub Jurek, and Erik Stafford. 2009a. "The Economics of Structured
Finance." Journal of Economic Perspectives, 23(1): 3-25;
Eichner, Matthew J., Donald 1. Kohn, and Michael G. Palumbo (2010). "Financial
Statistics for the United States and the Crisis: What Did They Get Right, What Did They
Miss, and How Should They Change?" Finance and Economics Discussion Series 201020, Federal Reserve Board;
Heitfield, Erik (2010). "Lessons from the Crisis in Mortgage-Backed Structured
Securities: Where Did Credit Ratings Go Wrong?" in Re-Thinking Risk Measurement
and Reporting -- Uncertainty, Bayesian Analysis and Expert Judgment (Ed. Klaus
Boeker), Risk Waters: London. 2010;
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Joint Forum (2008). Credit Risk Transfer: Developments from 2005 to 2007. BIS: Basel.
July 2008. (http://www.bis.org/publ/joint21.pdf?noframes=I);
Daniel M. Covitz, Nellie Liang, and Gustavo A. Suarez, "The Evolution of a Financial
Crisis: Panic in the Asset-Backed Commercial Paper Market," Federal Reserve Board
Finance and Economics Discussion Series 2009-36,
(http://www.federalreserve.gov/Pubs/Feds/2009/200936/200936pap.pdf); and
Paul Tucker, "Shadow Banking, Financing Markets and Financial Stability," 21 January
2010 (http://www.bankofengland.co.uklpublications/speeches/20 10/speech420.pdf).
Thank you for the opportunity to address these issues. I wish you every success
as you work to complete your analysis and final report.
Sincerely,
/J-P-cc: Christopher Seefer, Assistant Director & Deputy General Counsel
Wendy Edelberg, Executive Director
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@FedFRASER