Full text of Financial Crisis Inquiry Commission : Documents Relating to the Financial Crisis of 2007-2009 : Official Transcript : Hearing on "Too Big to Fail: Expectations and Impact of Extraordinary Government Intervention and The Role of Systemic Risk in the Financial Crisis.", Wednesday, September 1, 2010, Dirksen Senate Office Building, Room 538, Washington, D.C.

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UNITED STATES OF AMERICA

FINANCIAL CRISIS INQUIRY COMMISSION

Official Transcript

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Hearing on
"Too Big to Fail:

Government Intervention and The Role of Systemic Risk in the

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Expectations and Impact of Extraordinary

Financial Crisis."
Wednesday, September 1, 2010, 9:00a.m.

Dirksen Senate Office Building, Room 538

Washington, D.C.

COMMISSIONERS

PHIL ANGELIDES, Chairman

HON. BILL THOMAS, Vice Chairman

BROOKSLEY BORN, Commissioner

BYRON S. GEORGIOU, Commissioner

SENATOR ROBERT GRAHAM, Commissioner

KEITH HENNESSEY, Commissioner

DOUGLAS HOLTZ-EAKIN, Commissioner

HEATHER MURREN, COMMISSIONER

JOHN W. THOMPSON, COMMISSIONER

PETER J. WALLISON, Commissioner

Reported by: JANE W. BEACH, Hearing Reporter

PAGES 1 - 285

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SESSION I:

WACHOVIA CORPORATION:

SCOTT G. ALVAREZ, General Counsel

Board of Governors of the Federal Reserve System

JOHN H. CORSTON, Acting Deputy Director, Division of

Supervision and Consumer Protection,

U.S. Federal Deposit Insurance Corporation

ROBERT K. STEEL, former President and

Chief Executive Officer, Wachovia Corporation

SESSION II:

LEHMAN BROTHERS

THOMAS C. BAXTER, JR., General Counsel and Executive

President, Federal Reserve Bank of New York

RICHARD S. "DICK" FULD, JR., Former Chairman and

Chief Executive Officer, Lehman Brothers

HARVEY R. MILLER, Business Finance & Restructuring

Partner, Weil, Gotshal & Manges, LLP

BARRY L. ZUBROW, Chief Risk Officer,

JPMorgan Chase & Co.

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Vice

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P R O C E E D I N G S

(9:01 a.m.)

CHAIRMAN ANGELIDES:

Good morning.

I would like

to call to order the meeting and hearing of the Financial

Crisis Inquiry Commission.

To Fail:

Government Intervention and The Role of Systemic Risk In The

Financial Crisis."

Today's hearing on "Too Big

Expectations and Impact of Extraordinary

Good morning.

I am honored to welcome you as we

open the last in a year-long series of public hearings held

in Washington and New York examining the cause of the

financial and economic crisis that has gripped our Nation.

Sadly, while the facts of this crisis may appear

clearer through our rear-view mirror, the trauma is by no

means behind us.

statistics make it clear that too many people are searching

for jobs, trying to hold on to their homes, and praying they

can salvage teetering businesses.

Our country continues to struggle.

The

As we wind up our investigation and assemble our

findings, this Commission is determined to peer behind these

painful statistics and to help the American people

understand how this calamity came to be.

Beginning next week, we will hear from some of

the people who have been most devastated by the crisis in

communities around the United States.

We will hold a series

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of four field hearings in the home towns of some of the

Commissioners to learn more about how the seeds of this

crisis were sown on the ground.

The Commission will be in Bakersfield,

California, on September 7th; Las Vegas on September 8th;

and Miami on September 21st; and Sacramento on September

23rd.

We’ll be looking at a range of issues from

mortgage fraud and predatory lending practices to the

struggles of community banks and the fallout of this

financial collapse on neighborhoods and small businesses.

Since our first public hearing we have been on a

journey together following the evidence wherever it has

taken us.

Americans have asked: trying to figure out how a web of

events that ensnared Wall Street came to strangle Main

Street.

We have puzzled over the same questions that many

Today we are going to examine how a set of major

financial institutions became too big to fail, and why the

government decided to spend trillions of taxpayer dollars to

salvage some of those institutions, and the financial system

as a whole.

What we know from history is that taxpayers

should feel at risk when major financial firms veer toward

collapse.

For decades following the Great Depression,

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government intervention was rare.

But since the 1970s, bank

bailouts have become more frequent and costlier.

What began in 1974 with Franklin National Bank

grew into a longer list of bank rescues through the 1980s

and '90s.

First City, First Republic, MCorp, and the Bank of New

England.

First Pennsylvania Bank, Continental Illinois,

It now seems almost quaint that these

institutions were once considered too big, or too important

to fail.

generation ago.

banks in the country tripled in size between 1998 and 2007,

leaping from $2.2 trillion to $6.8 trillion.

Today we have megabanks of a scale unimagined a
The combined assets of the five largest

The 10 largest banks expanded their share of

assets in the banking industry from 25 percent to 55 percent

between 1990 and 2005.

Mae and Freddie Mac held or guaranteed assets of

approximately $5 trillion.

And prior to their collapse, Fannie

Time and again we have watched as financial

institutions have taken on more risk, used more leverage,

and chased bigger profits.

taxpayers have been handed the bill and warned that they

must save the Nation's financial system from perils created

by the banks.

When things have unraveled,

To my mind, we have been living in a kind of

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financial groundhog day.

course, and then we repeat what we have done before.

people have asked this Commission whether the government

during the most recent panic did the right thing to toss

flotation devices to major financial firms while most of

America took on water.

We vow to wake up and change

The real question before us is:

with only two choices?

Many

How do we end up

our world sink.

Either bail out the banks, or watch

Many Americans believe that reckless financial

institutions and greedy executives made appalling bets and

came away not just unpunished but with a windfall of cheap

capital that made them even more profitable.

justifiably angry that top executives pocketed big bonuses

with taxpayer money, and they rightly worry that the largest

surviving financial institutions are not just too big but now

too big and too few to fail.

They remain

Over the next two days we are going to hear from

witnesses who will answer questions about how and why these

financial institutions were allowed to grow and take on so

much risk.

We are going to explore how the financial system

became increasingly interdependent and interconnected.

are going to learn more about how the government grappled

with the crisis and then determined why certain banks and

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not others were deemed too big to fail.

whether the expectation of bailouts at taxpayer expense

served to encourage greater risk-taking by the financial

sector.

And we will explore

As we begin this hearing, let me note that the

Commission staff has produced another in a series of

excellent background reports located on our website:

fcic.gov.

financial institutions during the decades leading up to the

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The report dissects the governmental rescues of

crisis that we are probing today.
In closing, before I turn the microphone over to

Vice Chairman Bill Thomas, let me thank him for all his hard

work and cooperation in what has been a very long and hard

journey in service to this country.

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Let me also commend Commissioners Holtz-Eakin and
Commissioner Georgiou for taking the lead on this hearing.

Mr. Vice Chairman, the microphone is yours.

VICE CHAIRMAN THOMAS:

Thank you, Mr. Chairman.

One of the things this Commission is not required to do--

thank goodness--is to recommend policy measures to deal with

the potential we found ourselves in in the future.

frankly, that on the one hand an easy job to do, and on

another an almost impossible job to do.

commission together, that is almost always the seam which it

rips apart.

Because,

And when you bring

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Rather--I think wisely--Congress asked us to try

to understand and explain the circumstances surrounding the

crisis:

what cause this particular financial crisis.

When I was younger--and I guess I have to say in

the early days of television--there was a program hosted on

CBS by Walter Cronkite called "You Are There."

go back to periods in history.

event was evolving, there would be a reporter's approach to

discussing that particular period in history.

And it would

And while that particular

To a certain extent, that is what we are asking

you folks and the other panelists, including Chairman of the

Federal Reserve Ben Bernanke and Sheila Bair of the FDIC, to

do in assisting us in understanding what happened.

the real difficulties is to deal with something like too-

big-to-fail and assume it is something you can define in the

abstract.

One of

It is really an adjective.
And what wouldn't be of concern in a normal

situation becomes one in a situation in which a series of

events have occurred.

an action taken in anticipation of what might occur.

you hope there are a series of nonevents which make it very

difficult to prove that the decision that you made at the

time was the right one.

hindsight, Monday-morning quarterbacking game.

It is almost an expectation.

It is
And so

And it invites everyone to play the

So it clearly is about the context in which

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decisions are made.

And of course that is the policymaker's

worst nightmare.

that Justice Potter Stewart found himself in on the Court

when they were faced with defining "obscene."

sit down and define obscene in a series of phrases or

sentences?

ever be given:

I have often referred to the situation

How do you

And he gave the best answer that I think could
I know it when I see it.

Now unfortunately many of the decisions that were

made which brought about the determination to intervene were

behind closed doors, with some detail available to us but

not nearly enough to explain to the American People what

happened.

And so we are really asking you folks to do the

best you can to provide us with a degree of understanding

that our investigations have led us to believe, that there

were a series of events that occurred that the American

People would like to have a bit more knowledge about.

This isn't the first time we have investigated

this idea of too big or too important or too interconnected

to fail in terms of institutions, and it is not going to be

the last investigation that we have.

ability to focus on two case studies:

Brothers, as an example of decisions that were made that

resulted in different outcomes.

But we do have the
Wachovia and Lehman

I am also pleased to underscore the Chairman's

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comment about our hearings in various regions of the

country.

was in New York, investigational hearings; and we are now

going to turn to what I think is one of our important

assignments under the statute, and that is to hold so-called

"field hearings," or informational, or listening hearings so

that we can begin talking to those folk who really represent

the last domino.

These have been all in Washington, save one that

Because we have talked about a series of dominoes

falling on other dominoes, and we are going to be looking at

the last domino.

them, people who were involved, a long-time involvement in

business activities, and housing, and various financial

services, who didn't have another domino to fall against;

they simply fell on their numbers.

Many of them are community banks.

And that is the end result.

Many of

The cliche is:

From

Wall Street to Main Street.

buck stopped, where the buck was denied, and where the

failure to make that buck has had such a significant impact

on the American People.

And Main Street is where that

So thank you, Mr. Chairman.

I look forward to

the questions as we continue to try to understand what

people in particular contexts came to determine was the

criteria for too-big-to-fail.

CHAIRMAN ANGELIDES:

Thank you, Mr. Vice

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Chairman.
And now, gentlemen, thank you very much.

start our first panel.

have two case studies we will be examining today:

as well as Lehman.

We will

Chairman Bernanke and Chairman Bair.

As the Vice Chairman indicated, we
Wachovia,

And tomorrow morning we will hear from

Gentlemen, I would like to ask you all now to

stand and we will do what we have customarily done in these

hearings, which is we will swear the witnesses.

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If you

would please raise your right hand:
Do you solemnly swear or affirm under the penalty

of perjury that the testimony you are about to provide the

Commission will be the truth, the whole truth, and nothing

but the truth, to the best of your knowledge?

MR. ALVAREZ:

I do.

MR. CORSTON:

I do.

MR. STEEL:

I do.

(Witnesses sworn.)

CHAIRMAN ANGELIDES:

I thank each of you for your written testimony.

We have asked each of you to give a up-to-five-minute oral

presentation to the Commission this morning.

Thank you very much.

I am going to go from my left to my right to

start off today, alphabetically, also, logical order.

are going to start with you, Mr. Alvarez.

I am sure you

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have been here before, or in some room like this, and some

building around the Capitol, but I will indicate that at one

minute there is a light in front of you that will go from

green to yellow with one minute to go, and then will go to

red when your time is up at five minutes.

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With that, Mr. Alvarez, if you would begin your
testimony.
WITNESS ALVAREZ:

Chairman Angelides, Vice

Chairman Thomas, Members of the Commission:
I am pleased to testify about the acquisition of

Wachovia Corp. by Wells Fargo in the fall of 2008.

initial matter, it is noteworthy that the Federal Reserve

was not requested to, nor did it in fact provide any

assistance using its emergency lending authority under

Section 13.3 of the Federal Reserve Act in connection with

the acquisition of Wachovia.

assistance under its extraordinary authorities.

As an

Nor did the FDIC provide any

The agencies were prepared to invoke the Systemic

Risk Exception to allow the FDIC to provide extraordinary

assistance if needed to reduce the potential adverse effects

of Wachovia failure on the economy.

was not in fact used and Wachovia was resolved by an

acquisition by Wells Fargo without any extraordinary

government assistance.

However, that authority

To understand these decisions, it is important to

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understand the context.

2008, Wachovia was the fourth largest banking organization

in the United States with assets of approximately $812

billion.

At the end of the second quarter of

Wachovia experienced significant losses during a

period of extreme financial turbulence and distress.

nation's economy was in recession, with housing prices

declining and economic growth stalled.

was also deteriorating quickly.

The

The financial system

Within the four weeks leading up to the sale of

Wachovia, Fannie Mae and Freddie Mac were placed into

conservatorship, Lehman Brothers filed for bankruptcy,

efforts by private investors to provide liquidity to AIG

failed, and the Federal Reserve provided it with temporary

liquidity using the Fed's emergency lending authority.

losses at a prominent money market mutual fund caused by the

failure of Lehman Brothers sparked extensive withdrawals

from a number of money market funds.

And

Then on September 25th, 2008, the FDIC seized and

sold Washington Mutual Bank, the largest thrift in the

United States.

Bank experienced significant withdrawals of funds by

depositors and wholesale providers of funds.

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The day after the failure of WaMu, Wachovia

It appeared likely that Wachovia would soon
become unable to support its operations.

On September 27

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and 28, both Citigroup and Wells Fargo began due diligence

reviews of Wachovia and indicated to federal regulators that

government assistance would be needed in connection with

each of their proposed bids to acquire Wachovia.

The Federal Deposit Insurance Act includes a

Systemic Risk Exception that allows the FDIC to provide

extraordinary assistance in the resolution of a bank if the

Treasury Secretary, in consultation with the President, and

with the recommendation of both the FDIC and the Federal

Reserve Board determines that the assistance would avoid or

mitigate adverse effects on economic conditions or financial

stability.

The Federal Reserve was concerned about the

systemic complications of the failure of the fourth largest

bank in the United States during this fragile economic

period.

after the events involving the GSEs, Lehman, AIG, and WaMu.

The failure of Wachovia, an organization that was considered

to be well capitalized, could lead investors to doubt the

financial strength of other organizations that were seen as

similarly situated.

Markets were already under considerable strain

Losses on debt issued by Wachovia could lead

creditors to stop funding other banking firms and cause more

money market mutual funds to break the buck, accelerating

runs on these and other money funds.

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This could lead short-term funding markets that

were already under extreme pressure in the fall of 2008 to

virtually shut down.

would be undermined by the worsening financial market

turmoil, and banking organizations would be less willing to

lend.

economic performance and higher unemployment.

These effects could contribute to materially weaker

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Business and household confidence

For these reasons, on September 28th the Board
unanimously recommended that the FDIC be permitted top

invoke the Systemic Risk Exception in order to assist in the

resolution of Wachovia that would avert serious adverse

effects on economic conditions and financial stability.

First Citigroup and then Wells Fargo bid for

Wachovia, and after a series of actions described in detail

in my written testimony Wells Fargo ultimately acquired

Wachovia in a transaction that did not require use of the

System Risk Exception.

To better prevent and prepare for situations like

this, the Federal Reserve has already adopted a multi-

disciplinary approach that makes better use of our broad

expertise in economics, financial markets, payment systems,

and bank supervision so that the Federal Reserve can

understand linkages among firms and markets that have the

potential to undermine the stability of the financial

system.

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We are also augmenting our traditional

supervisory approach that focuses on firm-by-firm

examination with greater methods that better identify common

sources of risk, and best practices for managing those

risks.

surveillance program for large bank holding companies that

will use data analysis and formal modeling to help identify

vulnerabilities at both firm level and for the financial

sector as a whole.

And we have developed an enhanced quantitative

We are also working actively to implement the

provisions of the Dodd-Frank Act which addressed a number of

gaps in the statutory framework for supervision.

particular, we are developing enhanced capital risk

management, liquidity, and other requirements that would be

applicable to large systemically important financial

organizations, as well as developing resolution plans and

other plans under the Act.

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CHAIRMAN ANGELIDES:

Can you wrap up, please, Mr.

Alvarez.

WITNESS ALVAREZ:

I appreciate the opportunity to

describe these events and the Federal Reserve's role, and I

welcome your questions.

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CHAIRMAN ANGELIDES:

Thank you very much, Mr.

Alvarez.
WITNESS ALVAREZ:

Thank you.

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CHAIRMAN ANGELIDES:

WITNESS CORSTON:

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morning.

Mr. Corston.

Thank you very much, and good

I appreciate the chance to be here.
Chairman Angelides, Vice Chairman Thomas,

Commissioners:

I appreciate the opportunity to testify on

behalf of the Federal Deposit Insurance Corporation to

discuss the challenges faced by regulators in resolving

large, complex financial institutions prior to the passage

of the Dodd-Frank Act, and the collapse and sale of

Wachovia, and the measures taken to improve the FDIC's

supervision and resolution processes.

Before I begin my formal remarks, allow me to

briefly introduce myself and my roles and responsibilities

at the FDIC.

I am John Corston, Acting Deputy Director of the

Division of Supervision and Consumer Protections, Complex

Financial Institutions Branch.

oversee the large insured depository institution program.

This program provides forward-looking assessments of insured

depository institutions over $10 billion in assets.

Part of my duties are to

The FDIC's statutory authority to resolve

depository institutions is governed by the FDIC Improvement

Act of 1991, known as FDICIA, which requires the FDIC to use

the least-costly resolution method, and to minimize

expenditures from the Depository Insurance Fund.

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The least-cost test involves a cost analysis of

possible resolution alternatives based on the best available

information at the time.

the least-cost requirement for certain extraordinary

circumstances under the System Risk Exception that was

described by Mr. Alvarez.

FDICIA includes an exemption to

In the case of Wachovia, severe time constraints

and limited available information significantly limited the

ability of the FDIC to develop resolution options.

The FDIC felt that a rapid failure of Wachovia

could have resulted in losses for debtholders and

counterparties, intensified liquidity pressures on other

U.S. banks, and created significant adverse effects on

economic conditions and the financial markets globally that

was already experiencing severe market instability due to a

succession of crises of large institutions.

These factors led to an unprecedented decision to

use the System Risk Exception.

bankruptcy in early September in 2008, Wachovia experienced

significant deposit outflows.

Wachovia increased over the evening of September 25th when

two regular Wachovia counterparties declined to lend to the

firm.

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Following the Lehman

Liquidity pressures on

As of the morning of Friday, September 26th,
Wachovia, the primary federal regulatory, the Office of the

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Comptroller of the Currency, indicated to the FDIC that the

institution's liquidity position remained manageable.

However, by the end of the day Wachovia's situation worsened

and it faced a near-term liquidity crisis.

This set into motion a highly accelerated effort

to find and acquire for an institution that would provide

protection of depositors and minimize damage to the wider

financial system.

As noted earlier, severe time constraints,

limited available information, and complexity and size of

Wachovia led to government's approval of the System Risk

Exception and the acquisition of Wachovia by Citigroup with

government assistance.

transaction was superseded by a bid by Wells Fargo to

acquire Wachovia without government assistance.

In the end, however, the Citigroup

While some have tried to draw parallels between

Wachovia and Washington Mutual, these situations were very

different.

condition of stressed institutions, critical in developing

strategies, in the case of Washington Mutual, the FDIC had

adequate time to develop strategies and understand the risks

associated with those strategies.

the FDIC wasn't informed until the weekend before its

collapse and, as a result, had very limited information that

could be used to understand the market implications,

Having the ability to analyze the financial

In the case of Wachovia,

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especially in a market that was extremely unstable, or

develop a resolution strategy.

In response to these challenges during the

financial crisis, and aided by new regulatory tools made

available by Dodd-Frank, the FDIC has taken a number of

steps to improve our supervisory and potential resolution

responses for systemically important institutions.

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To address undue restrictions under the 2002
Interagency Agreement that governed our backup examination

authorities, the FDIC and the FDIC Board of Directors

approved a Memorandum of Understanding last month.

Memorandum of Understanding provides the FDIC authority to

conduct special examinations and is not limited--and

acknowledges the FDIC Board of Directors' authority to

direct special examinations should circumstances warrant.

The

Furthermore, the Dodd-Frank Act provides the FDIC

with broad new authorities not available during the crisis

to close and liquidate systemically important firms in an

orderly manner.

develop resolution plans known as "Living Wills"; statutory

language to affirm the FDIC's enhanced backup examination

authority, and a broad resolution authority of systemically

important institutions.

These tools include the requirement to

In closing, the FDIC's improved supervisory tools

and expanded on-site presence, better access to information,

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broader resolution powers to allow it to more effectively

perform its role in managing systemic risk going forward.

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I would be pleased to answer any questions from
the Commission.

CHAIRMAN ANGELIDES:

Mr. Steel?

WITNESS STEEL:

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Chairman Angelides, Vice

Chairman--

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Thank you, Mr. Corston.

CHAIRMAN ANGELIDES:

I think your microphone, Mr.

Steel?
WITNESS STEEL:

Chairman Angelides, Vice Chairman

Thomas, and Members of the Commission:
Thank you for the opportunity to appear here

today before the Financial Crisis Inquiry Commission.

name is Robert Steel and I served as CEO of Wachovia from

July 11th, 2008, until December 31st, 2008.

The Commission has requested that I address a

number of issues, including the deterioration of Wachovia's

credit portfolio in 2008, and the Company's discussion with

potential merger partners in late September and early

October of 2008.

As the Commission is aware, the housing market

deteriorated throughout 2007 and 2008.

worsening outlook for housing prices, changing borrower

behavior, and mark-to-market valuation losses on Wachovia's

In light of the

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residential mortgage-backed securities and collateralized

debt obligations and leveraged lending portfolios, Wachovia

reported a loss in the first quarter of 2008 of $707

million.

Second quarter losses, which like the first-

quarter 2008 losses had been calculated prior to my arrival

on July 11th and amounted to $9.1 billion, included a $5.6

billion loan loss provision.

worsening housing and economic conditions and, more

These losses reflected

specifically, anticipated future losses in Wachovia's loan

portfolio, primarily Wachovia's Golden West portfolio.

In the late summer and autumn of 2008, a series

of unexpected and unprecedented events occurred in rapid

succession in the financial services industry that increased

the uncertainty and stress in the financial markets.

These events included the conservatorship of

Fannie Mae and Freddie Mac on Sunday, September 7th, 2008;

the bankruptcy of Lehman Brothers holdings; and the

acquisition of Merrill Lynch by Bank of America announced on

Monday, September 15th, 2008, and growing concerns about the

viability of AIG which later culminated in a transaction in

which the Federal Reserve required most of AIG's equity.

On Thursday, September 25th, in an unusual action

the Office of Thrift Supervision announced the seizure of

the largest savings bank in the United States, Washington

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Mutual Bank.

Mutual into FDIC receivership followed by a sale to JPMorgan

for approximately $1.9 billion.

And the subsequent placement of Washington

In addition, on September 25th, a tentative

agreement in the U.S. Congress regarding the

Administration's Economic Stabilization proposal collapsed.

The combination of these events from earlier in

September, the seizure of Washington Mutual on Thursday, the

25th, and the collapse of Congressional agreement regarding

the Administration's Economic Stabilization proposal,

precipitated a sharp downward turn in financial markets.

The cost to insure Wachovia's debt, as evidenced

by credit default spreads, increased substantially from

Thursday the 25th to Friday the 26th of September.

Friday, the 26th, there was significant downward pressure on

Wachovia's common stock and deposit base, and as the day

progressed some liquidity pressures intensified as financial

institutions began declining to conduct normal financing

transactions to Wachovia.

In light of these deteriorating market conditions

during the week of September 22nd, it appeared as though

Wachovia was no longer in a position to engage in the public

offering and private placement transactions necessary to

raise capital, which in turn was considered to be the best

method short of selling the company, for sustaining Wachovia

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in this tumultuous environment.

Headed into the weekend of September 27-28,

management advised the Board of Directors that in light of

the bank's inability to access the capital markets, Wachovia

had begun discussions with both Citicorp and Wells Fargo

regarding a possible merger, and that management intended to

pursue both options during that weekend.

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The failure of these negotiations could have
resulted in Wachovia filing for bankruptcy, and the national

bank being placed into FDIC receivership.

would have been a major impact on Wachovia's creditors,

counterparties, and employers more broadly on the U.S.

economy.

Such a result

On September 26th, Wachovia entered into a

confidentiality agreement with both Citicorp and Wells and

initiated subsequent negotiations with each of these banks

toward a possible acquisition of Wachovia.

Both Wells Fargo and Citicorp conducted extensive

due diligence investigations on Wachovia on September 27th

and 28th, and in a response to a request by Mr. Kovacevich,

the Chairman of Wells Fargo, Wachovia's outside counsel

prepared and transmitted a draft agreement and plan of

merger for the whole company to counsel for Wells Fargo.

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Representatives of Citicorp, on the other hand,
indicated to me their interest was to acquire only

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Wachovia's banking subsidiaries, with an FDIC guarantee and

assistance.

a residual entity with nonbank assets and other liabilities.

As a result, the transaction would have created

Sheila Bair, Chairman of the FDIC, on Sunday

contacted me by telephone and advised the FDIC believed that

no transaction with Citicorp or Wells could be effective

without government assistance.

in the FDIC's view Wachovia posed a systemic risk to the

banking system.

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Chairman Bair confirmed that

Subsequently, Chairman Bair directed

Wachovia to commence negotiations with Citicorp.
We then negotiated an agreement in principle

which I signed.

negotiations with Citicorp towards reaching definitive

agreements which would be presented to Wachovia's board and

shareholders for approval.

I participated on behalf of Wachovia in the

These negotiations began immediately and were

conducted in earnest and good faith by a team of Wachovia

employees and outside advisors.

extremely difficult.

These negotiations proved

On Thursday, the 2nd--

CHAIRMAN ANGELIDES:

22
23

Mr. Steel, if you could try

to wrap up as quickly as possible.
WITNESS STEEL:

Thank you.

Yes, sir.

We began to negotiate

the transaction in good faith with Citicorp, but then

decided to pursue the transaction with Wells Fargo.

26
1

Wachovia's Board of Directors approved the transaction later

that evening, subject to receipt of fairness opinions.

After receiving favorable fairness opinions, the next day,

Friday, October 3rd, Wachovia and Wells Fargo announced

their merger agreement to the public.

Thank you, sir.

CHAIRMAN ANGELIDES:

Thank you very much,

gentlemen, for your statements and for your written

testimony.

We are now going to proceed to Commissioner

questions.

I will begin the questions, followed by Vice

Chairman Thomas, and then by the lead Commissioners on this

research and investigative effort.

So I would like to talk a little bit about the

matters about which I spoke in my opening statement.

key question in my mind, or at least one of the key

questions is:

we faced across the system, and in this regard also, was

either to let the financial system collapse or to move in

and save very specific institutions.

The

How did we get to the point where the choice

I have been struck in reading the work of our

staff--the document I mentioned that's been posted on the

Web--about the pattern that has existed among many of these

institutions that then find themselves needing government

assistance, or certainly being in the category of either too

big to fail or too important to fail:

high growth, high

27
1
2

leverage, a set of risky investments.
And the one thing I want to focus on in my

question is essentially, with respect to the regulators, why

weren't there efforts taken to contain risk and to evaluate

systemic risk until the very end?

As I look at all the documentation all the way

through with respect to Wachovia, what I see is, I don't

really see either regulatory body who is here today, and the

OCC is not here today, but in all the reports I do not see

evaluations of systemic risk.

until the weekend really of September 27th, 28th, 29th,

until in a sense the run has begun in the wake of WaMu's

seizure by the FDIC.

In fact, I don't see those

So that is what I would like to focus on.

assist in my question, I would like to enter some documents

in the record.

17
18
19
20
21
22
23

They are:

The April 2007 Report of Examination of the
Federal Reserve;
The July 22nd, 2008, Report of Examination of the
Federal Reserve;
The August 4th, 2008, Report of Examination of
the Office of the Comptroller of the Currency;
And then with respect to the action taken by the

Fed, there are two memos from September 27th from Ms.

Jennifer Burns to Elizabeth Gress and John Bebe; and then

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1

another memo from Jennifer Burns to John Bebe on September

27th, a Fed document regarding--documents regarding

Wachovia's liability structure, as well as the

recommendation of the Richmond Fed with respect to invoking

the Systemic Risk Exception, which I believe was September

29th.

I would also like to enter into the record the

FDIC Resolution invoking the Systemic Risk Exception of

September 29th; the Memo of Recommendation of that same day;

as well as the meeting transcript and minutes of the FDIC

Board.

So now let me go to my questioning.

As I look at

Wachovia's growth, I see an institution I think much by

acquisition that goes from about $254 billion in assets in

2000 to $782 billion by 2007.

growth rate of 17.4 percent.

That is a compounded annual

By 2007, the tangible assets to tangible equity

leverage ratio was 23.3 to 1; uninsured deposits had climbed

to over $160 billion; and, Mr. Steel, as you mentioned and I

believe Mr. Corston may have also, the acquisition of Golden

West had led to losses of more than $10 billion.

Option ARM portfolio of Golden West was about three times

Tier One equity capital.

24
25

The Pay

As I look at what both the regulatory bodies have
done is, as late as 2007 the Federal Reserve in its Report of

29
1

Examination is rating Wachovia at a 2, which means safe and

sound.

Reserve downgrades Wachovia to a 3.

it said that there was only a remote--even though there was

a downgrade, there was only a remote threat to its continued

viability.

It is not until July 22nd of 2008 that the Federal
But even at that point

You cited the Fed Risk Management Oversight

issues, decentralized risk management issues.

concerns about subprime concentration.

You cited

The OCC downgrades

to a 3 on August 4th.

But what really strikes me--and I am going to

start with you, Mr. Alvarez, is all during this time as you

look at the reports of examination by the Federal Reserve

there is no look at systemic impact.

the director of banking supervision at the Federal Reserve

from 2006 to August 1st of 2009, does note that there were

many constraints.

issues of significant growth, and need to secure more long-

term funding, the need to acquire more capital, the fact is

that when there are discussions about trying to get the

institutions in a sense to build some bulwarks against those

concerns, Mr. Cole said that they ran into pushbacks from

firms.

Now Mr. Cole, who was

While the Fed discussed internally the

He also noted a 2007 study that there was concern

in the United States about losing, because of our regulatory

30
1

burden, losing out to London and other financial centers.

So there was a concern that if there was too much in a sense

regulatory oversight of the banks we would lose our

competitive advantage.

And there was also, Mr. Cole said, a real sense

that risk management practices at large financial

institutions had improved, and the industry had matured and

was fundamentally better than at identifying bubbles and

risks.

Mr. Cole also said that at the Federal Reserve

Bank of course the focus was on holding company impacts on

the depositories; that there really wasn't any look at

systemic risk.

So I would like to ask you to comment.

Was this

a big hole?

use the word "fail," but was there a hole in the system

where the Federal Reserve did not look at the systemic

impacts?

Did in fact the Federal Reserve, I'm going to

From what I can see, I don't see any look at that

until after the run begins on Wachovia.

WITNESS ALVAREZ:

So the various points that

Roger makes, Roger Cole makes, I think are correct.

point out that we operate under a statutory framework for

supervision.

I would

Our authority to examine, the criteria we are

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1

allowed to look at, who we are allowed to look at, the

degree of our investigation, is all governed by statute.

And one of the gaps in the statute, and one that is fixed by

the Dodd-Frank legislation, is that our focus by law is on

the individual safety and soundness of particular

institutions, not on the system as a whole, not a systemic

macro prudential point of view.

in the banking area that is granted that kind of authority

and oversight.

And there is no regulator

That is one of the things that emerged in this

crisis as a gap in the system.

that the Dodd-Frank bill addresses in a variety of ways.

addresses it by enhancing the authority of all the

regulators to look at the systemic effect, as well as what

we call the micro prudential, or the safety and soundness

effects of particular institutions.

That is one of the things
It

It also establishes a council that brings

together regulators of different markets and different

institutions so that gaps and systemic implications can be

observed, and can be monitored.

recommendations made to Congress.

And where there are gaps,

So I think part of it was the statutory framework

we were operating under.

were limited to the institutions we could look at.

required by law to defer to the primary regulatory of

We also, as Mr. Cole mentioned,
We are

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1

institutions that are otherwise regulated.

the bank, the broker dealer, and other regulated

institutions.

That includes

So while we had a good relationship with those

regulators and cooperated and shared information, it was

clear that the primary role belonged to somebody else.

CHAIRMAN ANGELIDES:

But let me just probe this a

little more.

Because again, you know, we are in the

hindsight business, and an the extent we are aware of that.

But if you see an institution growing by 17 percent

compounded annual growth rate, you know, you see a

tremendous wave of acquisitions and, I would stipulate, a

fair amount of risk being taken, and this has been a pattern

over time, the Fed did have the ability in the,

quote/unquote, "good times" to require more capital, to make

sure the bulwarks were there.

I mean, there's the old Biblical phrase, you

know, seven years of feast, seven years of famine, and I

think that families are often instructed, you know, save in

the good times for the tough times ahead.

state government myself, I know that a lot of states have

suffered because in the good times they did not put aside a

prudent reserve for the downturn.

24
25

Having come from

I mean, looking back on it, shouldn't the Federal
Reserve or the other regulators, seeing that kind of growth

33
1

rate, in a sense have built some kind of bulwark for what

would be an inevitable downturn of some scale?

WITNESS ALVAREZ:

So we did encourage a bulwark.

That is what capital is for.

even at the time it failed, was sizeable.

capitalized by all definitions.

And the capital at Wachovia,
It as well

Now the difficulty is when you are in a liquidity

crisis, capital may not be your saving grace.

You need to

be able to sell assets, or raise funding in some other way.

And that is what was happening in the fall of 2008.

Liquidity was drying up.

valuable as a bulwark.

And so capital became less

I also would point out that growth and size by

themselves are not bad.

Growth of the banking system tends

to mirror growth in the industrial and commercial entities

in the United States.

corporations, which there are many of in the United States,

find it convenient and helpful and very good for their

business to have large American company banks that can

finance the growth of these U.S. commercial and industrial

entities as well.

And large, multi-national

So growth isn't by itself a bad thing.

CHAIRMAN ANGELIDES:

I agree that growth, in and

of itself, is not bad.

you see a wave of acquisitions, and there has been a

But when you see 17 percent growth,

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1

pattern--let me just say, one thing that has struck me, as

you look at the staff report that has been put on the web,

is over time there is a pattern to these institutions that

do fall into trouble, which is aggressive growth, high

leverage, increasing concentration of risky assets.

And so I am again probing:

At any time prior to

the 27th of September, did you ever say we ought to look at

the systemic risk implications and/or that we ought to be

concerned about the rate of growth of these institutions and

10
11

the risk profile they are taking?
WITNESS ALVAREZ:

So as I mentioned, our ability

to look at the systemic effects was limited.

were doing was looking at the institution's ability to deal

with the risks it was taking on.

But what we

And as you know from the memorandum of

understanding and from the exam reports that you've just

released, the Federal Reserve was cognizant of the risks

that Wachovia was taking, and was urging Wachovia to address

those risks, to improve its risk management systems, to

increase its liquidity, to analyze more carefully its

capital needs.

We had a variety of efforts under way at Wachovia

and at other institutions to help them improve themselves so

that they would be in a better position individually to deal

with their difficulties.

35
1

Unfortunately, during the period 2008 it was a

very difficult time for institutions to address problems

that were beginning to emerge at those institutions.

was less funding available.

available.

There

There was less capital

Liquidity was scarce.
So we were identifying and stressing that

companies deal with problems as those problems were becoming

apparent, but we were in a disadvantaged economic situation

to address them.

CHAIRMAN ANGELIDES:

I am going to ask you a

couple of questions, Mr. Corston.

now I understand you weren't the primary regulator.

understanding is you had one examiner on site?

WITNESS CORSTON:

CHAIRMAN ANGELIDES:

It is really the same-My

That's true.
By the way, were you ever

blocked from access to Wachovia in investigations?

WITNESS CORSTON:

No.

CHAIRMAN ANGELIDES:

I know that with respect to

WaMu the FDIC has said it was blocked by the OTS in

participation in some of the exams at WaMu.

familiar with that?

WITNESS CORSTON:

CHAIRMAN ANGELIDES:

24
25

I am familiar with that, yes.
But not in the instance of

Wachovia?
WITNESS CORSTON:

Are you

Correct.

36
1

CHAIRMAN ANGELIDES:

All right.

But again I

guess one thing I want to ask you is, in your role as

essentially the backup regulator, but obviously with a

significant amount of at risk, did you ever look before--as

I look, again, at the trail I don't see any look at systemic

risk implications for the system prior to the September 29th

memos.

Is that an accurate characterization?

8
9

WITNESS CORSTON:

One of the things we did at the

FDIC was, obviously as an insurer we are looking at our

risks at the various insured institutions.

established what we referred to as the National Risk

Committee within the FDIC.

decision makers that include the division directors of our

insurance division, supervision division, and resolution

division.

But we had

And it is staffed with top-level

It also has the Chairman and the Vice Chairman of

the FDIC attend.

became concerned about, was the amount of liquidity in the

market, and the amount of structured products and the

complexity in those structured products, and what we felt

may be the excessive sensitivity to credit risk in some of

those structured products.

One of the issues that we had seen, and

We discussed that with our National Risk

Committee and essentially were involved in trying to get

more information as far as the sensitivity of those

37
1

structured products.

Wachovia was very involved in that area.

And we

had our dedicated examiner spend quite a bit of time working

with the primary federal regulatory, and the Federal Reserve

in getting information and background and reporting for that

committee.

You mentioned the issue of growth, and concern

that we may have over growth.

And as Mr. Alvarez points

out, growth isn't always bad.

But for the FDIC, if growth

results in higher risk or more complexity, it does become

more of a challenge for the FDIC.

For example, when they, "they, Wachovia,"

purchased Golden West, Golden West was what we would

consider an institution that was more of a monoline, having

really a single product in an option Adjustable Rate

Mortgage portfolio that was largely collateral-based.

And for the FDIC to have that level of embedded

risk in a single institution is problematic, and you can see

that with the results of Indy Mac, Countrywide.

absorption of Golden West into Wachovia allowed a monoline

institution with a single risk to go into a far larger

institution that had diversified risk.

The

Of course the issue with Wachovia is that it had

a lot of other risks that exposed it to sensitivities in the

market and liquidity in that market.

38
1

One of the things and questions you had about,

you know, was there something maybe we missed, I have to say

one of the toughest things as a supervisor and having to go

to my board of directors, it is tough to go and not have

options for them that are viable.

don't think that we fully appreciated was the sensitivity to

the capital markets in the funding markets to the credit

risk in some of these products, and how quickly that

pullback could be.

And one of the things I

With Wachovia, you see the ratings were 3.

actually had, to our LIDY system, had downgraded Wachovia to

what we call a C-negative in March of 2008, and essentially

saying that institution is subject to a downgrade within the

next 12 months.

subsequently they did downgrade that institution and we did

have concerns about it.

We had discussions with the OCC and

But the appreciation for the sensitivity to the

funding markets was something we did not have a full

appreciation for.

this institution stood out as one that really could not

weather that storm.

And when the markets became so displaced,

CHAIRMAN ANGELIDES:

All right.

Let me--but it

does seem to me, and one last comment, that there's--in a

sense, I mentioned in my opening statement, it is almost

like financial groundhog day; that we see these institutions

39
1

take--the pattern is very similar in terms of growth,

leverage, risk; and on the upside, we don't take the kind of

prudential steps that we should take.

Do you believe, in retrospect, that that was a

failure, or a big, gaping hole in the system?

don't see the kind of look at systemic risk and liquidity

prior really to the weekend after the run has begun.

you agree, just kind of 'yes' or 'no' that that was a big

gap?

WITNESS CORSTON:

Because I

Would

I would agree it's a statutory

gap because it was very difficult for us to, when an

institution was profitable, and when we're dealing with the

primary federal regulator that we were getting feedback that

the risks were adequately managed, very difficult to say the

growth, just the growth in itself, is the problem.

CHAIRMAN ANGELIDES:

WITNESS ALVAREZ:

before.

bill

All right.

Mr. Alvarez?

So I reiterate what I said

I think that that was a gap that the Dodd-Frank

is attempting to close.

CHAIRMAN ANGELIDES:

before I yield my time and then come back.

you, Mr. Corston, and I will ask Ms. Bair about this

tomorrow.

24
25

Okay, one more question
And this is for

She expressed some significant reservations about
the invocation of the System Risk Exception.

She, in the

40
1

transcript, talked about how she's acquiescing to the

decision; "I'm not completely comfortable with it," "whether

it's the best resolution, I don't know."

What was at the core of this concern?

WITNESS CORSTON:

She would be able to answer

that question.

The information that we presented to her

prior to the board meeting, and at the board meeting, was an

institution that was suffering extreme liquidity stress;

that something had to be done.

I am sure that board, including her, would have

liked far more information and far more time to make their

decision, and I know that was a concern.

CHAIRMAN ANGELIDES:

All right.

Mr. Alvarez, one

last question for you.

One of the things we are trying to

examine is why certain institutions were deemed too big to

fail, and why others weren't.

I look at the memos from the Fed, as well as the

memos from the FDIC, and I ask myself why didn't Lehman fit

that criteria.

and Wachovia in terms of systemic risk?

be in a position where they had enormous systemic risk, at

least according to the memos I saw, but one was in and one

was out.

24
25

I mean, what's the difference between Lehman

WITNESS ALVAREZ:
a list of systemically--

The both seemed to

So first of all, we don't have

41
1
2

CHAIRMAN ANGELIDES:

No, but you made a

determination.

WITNESS ALVAREZ:

--institutions--but I think, as

you'll find in the discussion this afternoon, the difficulty

with Lehman wasn't that it had a systemic effect; I think it

has shown that its failure did have a systemic effect; but

we didn't have the tools to do anything other than what we

did.

Lehman needed far more liquidity than the Federal

Reserve could provide on a secured basis.

And without that

security, we are not authorized to provide lending.

didn't have authority to provide capital.

enacted--

The TARP wasn't

CHAIRMAN ANGELIDES:

on that a little, Mr. Alvarez.

on March 9th, which I would like to enter into the record,

which is regarding the authority of the Federal Reserve to

provide extensions of credit.

that the statutory text, quote, "leaves the extent and value

of collateral within the discretion of the Reserve Bank."

Well, but let me probe you
I mean, you wrote an opinion

And you said at that time

You went on to say in that opinion that requiring

loans under 13.3 to be fully secure--I'm sorry, it's a 2009

opinion, I'm sorry, March of 2009.

requiring loans under 13.3 to be fully secured would, quote,

"undermine the very purpose of Section 13.3, which was to

You went on to say that

42
1

make credit available in unusual and exigent circumstances

to help restore economic activity," closed quote.

And the other thing--and I will get into it more

this afternoon--but was there ever an opinion rendered

during the course of the deliberations on Lehman that

legally credit could not be extended?

appears--and we'll talk about it this afternoon--that there

were many discussions about extending credit through the

Primary Dealer Credit Facility.

10
11
12

Because there

But the issue of kind of a legal stopper never
comes up, as far as I can see.
WITNESS ALVAREZ:

So there was no time to write a

legal opinion on the Lehman weekend.

incredibly quickly.

dealing with all of the collapse of Lehman.

time for that.

Everything happened

In the space of this hearing we were
So there wasn't

On the other hand, if I could explain my legal

opinion, the statute says that the Federal Reserve can lend

so long as the Reserve Bank is secured to its satisfaction.

The credit is either endorsed--that means guaranteed by

somebody else--or secured to the satisfaction of the Federal

Reserve Bank.

Collateral is one way that a Reserve Bank might

find it is secure.

makes it feel that it will be repaid.

It may be the value of the collateral
But the point is, it

43
1

has to be able to feel comfortable that it will be repaid.

CHAIRMAN ANGELIDES:

WITNESS ALVAREZ:

But here--

And there was not, at Lehman

going into that Monday, the belief that the Federal Reserve

would be repaid, because the collateral was inadequate.

It was a company that was failing.

It was a

company that did not have other sources of income to ensure

that it would repay the Fed.

or other source of funds to repay if Lehman did not.

And there was no third party

So the Federal Reserve believed that it would not

recover the funds it would give to Lehman, and that is why

it did not extend the credit.

CHAIRMAN ANGELIDES:

But very quickly, I just

want to ask you, did you ever do a--I know that the private

consortium went in and obviously was trying to value the

assets of Lehman, and I want to ask you because you happen

to be here this morning, I know that there was valuation,

but of course they're doing it in a compressed time frame

and you could argue the private consortium had some

motivation.

collateral analysis?

I've never seen a collateral analysis.

WITNESS ALVAREZ:

Just kind of yes or no, did the Fed ever do a
Did anyone in the Federal Government?

A written report on the value--

24
25

CHAIRMAN ANGELIDES:

Yes.

44
1
2

WITNESS ALVAREZ:

--of the collateral?

No.

There was no time for that, nor

CHAIRMAN ANGELIDES:

No legal opinion.

Well,

except, Mr. Alvarez, let me point out, there was time for

extensive memos on Wachovia.

WITNESS ALVAREZ:

I would point out that also for

Lehman Brothers, unlike Wachovia, we weren't the supervisor.

So we didn't have the access to information or the

understanding of the company in the same way we do of

Wachovia where we are the supervisor, and it is a little

different situation.

12
13

CHAIRMAN ANGELIDES:

All right.

Thank you, Mr.

Alvarez.

WITNESS ALVAREZ:

Thank you.

CHAIRMAN ANGELIDES:

VICE CHAIRMAN THOMAS:

Vice Chairman.
Thank you, Mr. Chairman.

I think I have an extraordinary opportunity, given the fact,

Mr. Alvarez, you have been at the Federal Reserve I believe

from '04 to the present day?

20
21

WITNESS ALVAREZ:

I actually was born at the

Federal Reserve.

(Laughter.)

VICE CHAIRMAN THOMAS:

24
25

money.
(Laughter.)

Nestled in a basket of

45
1
2

VICE CHAIRMAN THOMAS:

Excuse me, Federal Reserve

not true.

3
4

Well, no, that I wish, but

Notes.

(Laughter.)

VICE CHAIRMAN THOMAS:

Mr. Corston, I understand

that you were born at the FDIC in '87, and have been there

ever since?

WITNESS CORSTON:

That's correct.

VICE CHAIRMAN THOMAS:

And, Mr. Steel, you were

at Treasury, the Under Secretary of the Treasury for

Domestic Affairs from '06 to '08, but then extraordinarily

you moved in July of '08 to Wachovia.

WITNESS STEEL:

VICE CHAIRMAN THOMAS:

Yes, sir.
So that you would be part

of this string of decisions and results.

So I will play Walter Cronkite and "You Are

There."

of the Ways and Means Committee, cognizant of Article I of

the Constitution which reserves all powers to the Congress

to make laws affecting the revenue of the United States; and

that all three of you gentlemen, when you were in

government, two of you still in government, the third when

you were in government, were in Article II, the Executive

Branch, on the execution of the laws of the United States.

I am asking these questions as the former Chairman

46
1

When we talk about that--and you were there, Mr.

Corston, I understand, on that meeting of the board of

directors on September 29th--

WITNESS CORSTON:

That's correct.

VICE CHAIRMAN THOMAS:

a potential decision to deal with Wachovia.

--when you were looking at

Mr. Alvarez, on page 10 of your testimony you--

no, excuse me, on page 6 of your testimony you emphasized,

in the observance of the behavior of the FDIC meeting, on

page 6:

"On September 28th, the Board by unanimous vote

determined that compliance by the FDIC was the least"--met

all of those requirements.

"unanimous vote."

And so you emphasized the

It was a unanimous decision.

WITNESS CORSTON:

wasn't speaking about the FDIC Board.

16
17

VICE CHAIRMAN THOMAS:

Oh, you weren't speaking

about the--

18
19

Yes, that was my board.

WITNESS CORSTON:

I was speaking of the Board of

Governors.
VICE CHAIRMAN THOMAS:

I apologize.

What was the

vote, if you're allowed to tell us that in a public meeting,

of the Board of Directors?

WITNESS CORSTON:

VICE CHAIRMAN THOMAS:

WITNESS CORSTON:

The FDIC?
Yes.

Unanimous.

47
1
2

VICE CHAIRMAN THOMAS:
the FDIC?

WITNESS CORSTON:

VICE CHAIRMAN THOMAS:

It was a unanimous vote of

Correct.
Was it, in the vernacular,

an easy unanimous vote?

(Pause.)

You know what I mean.

WITNESS CORSTON:

9
10

I got very few questions.

Just talk.

I was a presenter, I would say

I think, though, that it was not

an easy decision for those making them.

VICE CHAIRMAN THOMAS:

What was part of the

concern about making that decision on the part of the Board

of Directors?

WITNESS CORSTON:

That's easy to answer, and it's

the same problem I had.

We dealt in very short time frames

with a lot of gaps in information.

information regarding Wachovia, we had very little

information regarding really the outside and collateral

impact which we knew could be substantial, but it was hard

to calibrate a measure.

And while we had

So when we presented our case, we knew this to be

a very, very significant factor that decisions were going to

be made upon, yet it was very difficult to provide hard

facts.

And I deal with institutions where, generally

48
1

when I got up in front of my board, I present hard facts,

and it is fairly--whether you agree or not, at least you can

understand the fact set.

we had that evening, or morning.

VICE CHAIRMAN THOMAS:

And I think this was the challenge

And as you indicated to

the Chairman, what you liked to do was go into meetings with

viable options.

based upon fact, that you had some certainty on presenting a

course of action, if that course of action was accepted.

And obviously viable options are those

Was there concern in the FDIC, or in the

Chairman, or others, about the potential of the FDIC holding

the bag?

the FDIC of this agreement?

WITNESS CORSTON:

That there would be some concern about costs to

With regard to the case that I

presented, in our analysis the actual bid that was presented

by Citi and the analysis that we had from our field staff

working with the OCC and Federal Reserve, it really showed

that we had no loss exposure.

Now we were given, you know, a fact set that is

not entirely, you know, a 100 percent probability, but we

were very comfortable that the actual dollar exposure was

likely zero for the FDIC.

VICE CHAIRMAN THOMAS:

So that is why on page 10

of your testimony you said, as a result, quote, "there was

no expected loss to the FDIC associated with the

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transaction"?

WITNESS CORSTON:

Correct.

VICE CHAIRMAN THOMAS:

Mr. Alvarez, in your testimony on page 10, in

So you were home free.

terms of examining the arrangement, you say, under the

"Federal Reserve Assistance" in the middle of page 10:

Federal Reserve did not provide any emergency financial

assistance in connection with the Wells Fargo-Wachovia

merger."

"The

So in terms of taking care of your birth place,

there was no risk, financial obligation, or other financial

role that the Federal Reserve would play?

WITNESS ALVAREZ:

VICE CHAIRMAN THOMAS:

home free with this arrangement.

16
17
18
19

WITNESS ALVAREZ:
footnote.

That's right.

Yes.

That's right.

So the Federal Reserve was

I have to add a small

We weren't asked-VICE CHAIRMAN THOMAS:

Small in size, or small in

importance?

WITNESS ALVAREZ:

I think in both.

VICE CHAIRMAN THOMAS:

WITNESS ALVAREZ:

Okay.

The--while it is true we were

not asked, nor were we expected, to provide any emergency

assistance, Wachovia, as were many banks at the time, was

borrowing, the bank itself, at our discount window--

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1
2

VICE CHAIRMAN THOMAS:

The discount window was

open, but that's an ongoing, normal function.

WITNESS ALVAREZ:

Yes, exactly.

VICE CHAIRMAN THOMAS:

decision, that is part of your commitment.

WITNESS ALVAREZ:

VICE CHAIRMAN THOMAS:

8
9
10

And once you make that

That's right.
But it wasn't outside of

that-WITNESS ALVAREZ:

Correct.

VICE CHAIRMAN THOMAS:

That's right.

--that the Federal Reserve

was going to have any kind of exposure.

WITNESS ALVAREZ:

VICE CHAIRMAN THOMAS:

14
15

That's correct.
So the Federal Reserve is

home free; the FDIC is home free.
Mr. Steel, in your testimony I found on page 5

that your information was kind of secondhand.

in the middle of page 5, at your request, the Chairman very

shortly thereafter called Mr. Sherborn and provided details

on the proposed transaction, quote, "including that it would

not require any government assistance."

WITNESS STEEL:

VICE CHAIRMAN THOMAS:

For example,

Yes, sir.
And then lower on the

page, when you landed--you were actually in flight, so

things were happening while you were moving, and of course

this is at the time that you were at Wachovia after you had

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left the Treasury, it says:

Consistent with what she told

Mr. Sherborn, Chairman Bair described Wells Fargo's proposal

to me as requiring no government support, with no risk to

the FDIC Fund.

WITNESS STEEL:

Yes, sir.

VICE CHAIRMAN THOMAS:

But the solution, not

withstanding the fact that the FDIC took the unusual

measures in its minutes to move to a Citi-Wachovia

structure, was not talking about that arrangement, was she?

10
11

WITNESS STEEL:

No, sir.

She was speaking about

the proposed transaction by Wells Fargo.

VICE CHAIRMAN THOMAS:

And the proposed

transaction by Wells Fargo came after the FDIC had met and

decided, by unanimous vote, that it was appropriate to go

forward with the safeguards and the small risks of possibly

having FDIC funds exposed.

WITNESS STEEL:

VICE CHAIRMAN THOMAS:

Yes, sir.
On the 29th.

Right, Mr.

Corston?

WITNESS CORSTON:

Yes.

VICE CHAIRMAN THOMAS:

What happened on September

30th?

Steel, the Department of Treasury.

an IRS notice, No. 83, which changed a more than two-decade-

old regulation dealing with the acquisition of companies, in

This would be back at your old stomping ground, Mr.
There was at that time

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terms of whether or not the acquisition focused on the

acquisition for purposes of tax benefit rather than any of

the other reasons that firms might want to merge.

In fact, IRS issued an opinion which turned the

law on its head.

It didn't provide it--now we're familiar

with NOLs.

Committee, used to deal with Net Operating Loss reachback

because it was a way to transfer previous losses to current

situations, and previous profits to current situations where

We used to, the Congress and the Ways and Means

you wanted to shift time to provide assistance.

always on a fixed time that it was available, and it was

always across the board available.

dollar amounts, you were able to utilize them.

didn't, you didn't.

It was

That if you met the
If you

But in Notice 83, the IRS said it was available

to banks only to shift losses that would accrue to the

acquiring company.

So you were at Wachovia at the time, and

subsequently with the acquisition of Wachovia to Wells Fargo

you moved then to a position I understand on the board of

Wells Fargo.

Is that correct?

WITNESS STEEL:

Yes, sir.

After the closing of

the merger, several Wachovia--former Wachovia directors were

invited to join the Wells Fargo Board, and after a brief

period in January-February of '09 I did join the Board.

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VICE CHAIRMAN THOMAS:

Well I'm trying to

understand.

If I'm there, and you folks are in the

positions you are, let me in on when Treasury began looking

at what you called, Mr. Corston, "viable options," including

the reversal of a two-decade-old regulation which

significantly governed what you could or could not do in

trying to salvage financial institutions that you might

define as too-big-to-fail, because suddenly laying on the

table an ability to acquire a bank or a financial

institution in which the concern is failure, therefore

significant losses, could actually be incorporated by the

acquiring corporation and used to offset taxes?

And that was the choice that was made, not

withstanding the FDIC made the other choices.

reaction, Mr. Corston, to the September 30th announcement by

the IRS that they were changing the fundamental rules of the

game, which would clearly change the potential relationships

between these financial institutions that you folks were so

concerned about the day before in your minutes?

WITNESS CORSTON:

What was your

Well my reaction was more

towards the Wells Fargo, coming up with a viable bid as a

result.

option that the one we came to over the weekend.

24
25

And certainly that was far more palatable of an

VICE CHAIRMAN THOMAS:
end?

So the means justified the

You were very pleased with the fact that IRS made this

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change in the regulations, unilaterally, without

consultation with the Legislative Branch that has the

Constitutional responsibility to change the law.

In essence, they changed the law.

convenient.

on the previous deal, FDIC was okay.

okay.

leap at the opportunity to take this extreme, fundamental

change in the Tax Code brought about by an IRS notice?

It was appropriate.

But it was

It was a better deal.

But

Federal Reserve was

Why didn't you look at continuing the process and not

WITNESS CORSTON:

The issue on the weekend really

was the liquidity issue.

have enough liquidity to operate Monday.

concern, and a concern we presented to our Board.

We did not know if Wachovia would
And that was a

And the problem was, we just did not know.

But

we did know that the implications of them not being able to

operate, and the resulting impact on counterparties and

other institutions could be fairly significant.

So our decisions were made, as I said earlier,

unfortunately in a very, very compressed time frame with

really not a tremendous amount of information.

VICE CHAIRMAN THOMAS:

Mr. Steel, you were at

Treasury in an Under Secretary position from 2006 to 2008.

Was there any discussion in terms of Mr. Corston's viable

options of looking at this shift in the definition of what

you could do under the IRS notice?

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WITNESS STEEL:

No, sir, not that I'm aware of.

VICE CHAIRMAN THOMAS:

Was it brought up in any

discussions when you were desperately looking for a

solution?

Federal Reserve, and you all sit around, and you try to

resolve problems collectively, making sure that no one winds

up holding the bag, certainly not the Federal Reserve or the

FDIC, or, Mr. Steel as you characterize, there would be no

government exposure or cost.

10
11

Because I know Treasury talks to FDIC, and the

WITNESS STEEL:

No, sir, no discussions of this

technique or issue.

VICE CHAIRMAN THOMAS:

Mr. Corston?

WITNESS CORSTON:

There were none at my level.

WITNESS ALVAREZ:

None that I'm aware of.

VICE CHAIRMAN THOMAS:

So this immaculate birth

of an IRS notice which fundamentally changed the way in

which corporations could deal with the Tax Code on an

acquired corporation's losses was so significant that it

shifted your decisions to allow the Wells Fargo to go

forward.

21
22

Citibank was a little upset, weren't they?
Didn't they take some legal action?

WITNESS CORSTON:

VICE CHAIRMAN THOMAS:

That's correct.
And you probably weren't

supportive of that legal action, because it could have left

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a bit of exposure, not withstanding the size of it, but

exposure to the FDIC.

utilization of the regulation change?

in the FDIC about this is a better way to go?

You were supportive of this

WITNESS CORSTON:

Was there discussion

The discussions I was involved

with was with analyzing basically the two transactions.

the Wells Fargo transaction not requiring any assistance

with the FDIC or exposure was a far better proposal.

9
10
11

VICE CHAIRMAN THOMAS:

Right.

And

You're home free.

And we knew Federal Reserve is home free.
Mr. Steel, how can you characterize, or even

utilizing other people's characterizations because

apparently you support them by including them in your

testimony as an explanation, that there wouldn't be any

government cost to the IRS Notice 83 solution?

What it was was a significant loss of revenue to

the Treasury, unprecedented.

So how could you say there

was no cost to the government?

government as the Executive Branch.

WITNESS STEEL:

Unless you saw the

No, sir.

I believe that the way

I would frame this distinction is that drawing a distinction

between specific government support for an instant

transaction in one case versus a change in the IRS Tax Code

which was available to all others who might be in a position

to take advantage of it.

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VICE CHAIRMAN THOMAS:

WITNESS STEEL:

3
4
5

All other corporations?

All other institutions who fit

the qualifications to be able to take advantage of it.
VICE CHAIRMAN THOMAS:

Which were financial

banking institutions.

WITNESS STEEL:

Yes, sir.

VICE CHAIRMAN THOMAS:

It was--in the vernacular

we used to talk about it in terms of making these kinds of

decisions--it was a rifle shot.

specific group of institutions.

They changed the law for a

Did anybody think that was lawful?

I understand

it was convenient.

available on the 29th when the FDIC made its decision.

became available on September 30th, and Wells, sharpening

its pencil, by October 2nd decided this was a pretty good

deal, and that they could do it without any government

assistance.

It certainly was a solution that wasn't
It

How can you not call changing the Tax Code to

provide you with significant tax benefits doing it without

government assistance, as you describe, Mr. Steel?

taking money away from the taxpayers and the General Fund

through a change in the Tax Code "government assistance"?

WITNESS STEEL:

Isn't

I understand your perspective.

What I tried to describe was a distinction between support

for a specific transaction and support for what you just

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described as a group of people, meaning financial

institutions.

a difference.

And that being a distinction in my mind with

VICE CHAIRMAN THOMAS:

Well this isn't my

characterization.

A fellow who teaches law at the

University of Virginia that I got to know very well, because

we selected him as Chief of Staff of the Joint Committee on

Taxation, Professor George Yin, said, quote, "Did the

Treasury Department have the authority to do this?

I think

almost every tax expert would agree that the answer is no.

They basically repealed a 22-year-old law that Congress

passed as a backdoor way of providing aid to banks."

And of course what happened, once Congress

discovered what had been done by the IRS, they immediately

slammed the door on this provision, although I believe two

other banking institutions got through before the door was

closed.

I guess what just amazes me is, looking at this

time period, late September early October, there was a focus

on the FDIC making sure they were home free.

focus on the Federal Reserve making sure they were home

free.

Wells Fargo and for the assumption by Wells Fargo of

Wachovia, because it made it government assistance-free?

Well it wasn't.

There was a

The ends justifying the means was quite all right for

It cost the taxpayers to utilize this.

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And I guess what is so amazing to me, when you

begin to examine the options open to you, that I think a lot

of us have a concern about the kinds of discussions that

went on behind closed doors; what the options were that were

defined as viable, including up to changing the law of the

Internal Revenue Code to make it expedient to take a course

of action that didn't cost the FDIC anything, and it

certainly didn't cost the Federal Reserve anything.

characterize it as "no government assistance," "no

But to

government cost," is to tell me a whole lot more about those

key decision makers' view of the world at the time they had

to make decisions for the American People, for the American

taxpayers, and for the American Government.

I knew who you were looking out for.

reserve my time, Mr. Chairman.

CHAIRMAN ANGELIDES:

I'll

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18

Chairman.

Thank you, Mr. Vice

Mr. Georgiou.
COMMISSIONER GEORGIOU:

Thank you, Mr. Chairman.

I guess I'd like to, without overly belaboring the point,

like to follow up with Mr. Steel on the point that the Vice

Chairman made.

Do you still serve on the Wells Board?

WITNESS STEEL:

COMMISSIONER GEORGIOU:

much that Tax Code change benefitted Wells?

No, sir, I do not.
Okay.

Do you know how
Or whether it

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is still a continuing loss carryforward that's permitted

under that modification of the Tax Code?

WITNESS STEEL:

COMMISSIONER GEORGIOU:

(No response.)

COMMISSIONER GEORGIOU:

No, sir, I do not.
Does anybody here know?

Does anybody on our staff

know?

(No response.)

CHAIRMAN ANGELIDES:

Actually, in an analysis

provided,

benefit to date, but I believe that's their statement; that

they have not yet utilized or reaped any benefit to date,

but there are projections for future use and availability of

that credit.

Wells has contended that they have not reaped any

COMMISSIONER GEORGIOU:

And that's because they

haven't made enough money in the interim to use the loss

carryforwards.

I mean, I guess the point that I think the Vice

Chairman made, and I think anybody else--

CHAIRMAN ANGELIDES:

But I will say, on my time,

there was an estimate provided when the measure was

repealed, I believe, saying that the costs would be about $7

billion.

24
25

That's my recollection. But, Mr. Vice Chairman-VICE CHAIRMAN THOMAS:

And there is printed

information, and I will provide it for the record, that

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indicates that the difference between September 29 and

October 2nd was a 10-fold benefit to Wells Fargo in terms of

the tax provision.

COMMISSIONER GEORGIOU:

Well, I mean obviously,

you know, tax loss carryforwards are valuable in that they

shield future income from taxation.

day, although the FDIC didn't have to impact the Insurance

Fund, the Fed didn't have to provide direct assistance,

ultimately the taxpayers will be impacted by the diminution

So at the end of the

in revenue that would otherwise have been collected from

Wells when and if they utilize these tax loss carryforwards.

The point, I suppose, at the end of the day isn't

that that particular method was utilized, but the

characterization of it as "not government assistance."

was a different form of government assistance, that's all.

It was perhaps a delayed form of government assistance.

at the end of the day, the taxpayers will have less revenue,

which is the same as expending the same amount of money,

effectively, to impact on the taxpayer over time.

But

And I guess I was interested in some of the

things, Mr. Steel, that you said to our staff in the

interview that they conducted with you.

you said was the resolution process, you believed, should be

mean-spirited with all parties paying a price as a pedagogy

or methodology for resolution.

One of the things

I think that people should

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not be too big to fail, but given the concentration issue

how should people fail in a way that doesn't have ripple

effects.

Could you elaborate upon that, in your view?

WITNESS STEEL:

Surely.

I think I would start

with what I believe are the right principles.

would talk about preventative perspectives.

And then I

right approach, once events develop.

And then the

So let me try with that methodology.

recounted from my interview, my personal belief is that no

institution should be too big to fail.

reality.

involvement, in particular with depository institutions,

sets up a situation that is complex with regard to moral

hazard and the relationship between these institutions,

where we have a complicated message that we are not crystal

clear on.

As you

But we do have a

And that is that the nature of the government

So that is the reality.

But my belief is that no

institution should be too big to fail.

So then what do we

do about that?

I believe that there are certain things we do in

advance, and some of them Mr. Alvarez described, whether it

is living wills, more effective regulation and supervision,

and efforts to understand systemic risk, as the Chairman

discussed in great detail.

Those are examples of things we

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2

can do in advance.
Then I think you get to the very complex issue of

when institutions run into trouble what is the method by

which, if you adopt my perspective that no institution

should be too big to fail, what do you think should be the

methods by which institutions are wound down or fail so as

to have the least effect on other people and other parties?

And there my view is that we have processes for

bankruptcy, and that we should use as much of the processes

characterized by bankruptcy as we possibly can before we get

to the issue of thinking about government support.

is the philosophical perspective I would bring to that

second part of the discussion.

COMMISSIONER GEORGIOU:

So that

Well a lot of us on this

Commission share that view, but one thing that is our charge

is to attempt to evaluate and elucidate for the American

People how it is that we got to the point where so many

institutions were provided with extraordinary governmental

assistance.

And of course they only--the policymakers only

face the choice of whether to save an institution when they

are on the verge of failure, which of course customarily

occurs not in an isolated manner when one particular

institution fails in a time when it is generally a rosy

economic circumstance--if that occurs, quite often we allow

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them to fail because it is not really going to impact anyone

else.

The problem is when circumstances present

themselves, as they did in 2007 and 2008 when liquidity was

being withdrawn from the marketplace and was difficult to

obtain.

And as we look at those issues, we are doing so

with the hope that we will learn something about it that

might enable us to address these matters differently on a

go-forward basis.

One concern I have is that it appears that, just

the top six largest banking organizations in American--that

would be Bank of America, JPMorgan Chase, Citigroup, Wells

Fargo, Goldman Sachs, and Morgan Stanley--their assets grew

from 17 percent of GDP in 1995 to 58 percent of GDP in 2007

as we approached the high point of the financial crisis.

But they are 63 percent as of the end of 2009.

So they are not any smaller.

Those six banks

have a 5 percent greater size relative to GDP now than they

did during the crisis.

will start with you, Mr. Steel, because you've got long

experience in the private sector as well as the public

sector, and then I will turn to the other two of you if I

can:

So my question to you, and I guess I

Are we really any less likely to be compelled to

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save one of these six very large and very interconnected

financial institutions in the event that we have a liquidity

crisis anywhere near as severe as we had before?

And I raise this because it seems to me that

there are conceivable circumstances in the future that could

lead there.

as large in number as residential real estate loans, but if

we all concede that the loss of value in the residential

real estate marketplace was a significant factor as a

Obviously commercial real estate loans are not

trigger of the crisis, you know, could we face a similar one

as the commercial real estate losses have to be absorbed in

these institutions over the next few years?

And are we any better positioned today than we

were two years ago to avoid the need to provide

extraordinary governmental assistance to these institutions?

Mr. Steel?

WITNESS STEEL:

I will revert back to the

methodology I was describing.

building or in the process of building better capabilities

for thinking ahead, thinking systemically as the Chairman

suggested, having a more robust perspective from supervisors

and regulators, and are we building tools so that we are

more aware and have a better line of sight on these

institutions?

I think first it is, are we

I think that is in the process of happening.

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Then you get to the second part of your question,

and here I think we have to be very disciplined about

setting into process now methods by which we deal with this

before we get into the situation.

As you said, quite correctly, when you have a

situation like we had in 2008 where several institutions are

being stressed at the same time, then you need to know in

advance what are you going to do?

liked or preferred some of the perspectives of recognizing

that we have to say in advance we are going to move in this

direction and be more tough-minded with regard to potential

bankruptcies and things like that.

COMMISSIONER GEORGIOU:

that?

And that is why I have

Well but how do you do

I mean, you have to do it well in advance of the

crisis, do you not?

WITNESS STEEL:

COMMISSIONER GEORGIOU:

18
19

Yes, sir.
Do you think we are doing

that now?
WITNESS STEEL:

I think that this is all yet to

be determined.

be writing--I think he said to me before we began

testifying--50 rules in the next 18 months.

the work of implementing this legislation that we will see

how people do with this.

As Mr. Alvarez was saying, they are going to

COMMISSIONER GEORGIOU:

Okay.

It will be in

Mr. Corston?

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WITNESS CORSTON:

I think we certainly have an

opportunity to address these issues that we've faced in the

past.

of assets in the largest institutions, under our current

process for resolutions you will notice that, to resolve a

large institution it generally is absorbed by another

institution.

8
9

One of the points you raise about the concentration

So, giving the example of Washington Mutual, it
gets absorbed by JPMorgan Chase, and now we have a larger

JPMorgan Chase.

Wachovia is absorption by Wells Fargo, and now we have a

larger Wells Fargo.

if you look at each crisis the concentration of assets

afterwards, we see more and more concentration in banking

assets in larger institutions.

the--before Dodd-Frank, that really was our only way out for

a large institution, to have it absorbed by another

institution.

We look at Wachovia, and the solution for

Those statistics you mentioned, I think

And frankly, you know, under

One of the things as the FDIC looking to resolve

an institution, you need time.

You need information.

you need to be able to understand structures.

And

will provide that information.

Dodd-Frank

One I think of the key pieces of Dodd-Frank is

that when institutions make decisions right now they make

them with sole focus on the bottom line.

So if you are

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sitting at Citigroup, JPMorgan Chase, you are not concerned

with your structure necessarily, if it had to be wound down

in an orderly manner.

That isn't a business decision.

That doesn't cross your mindset.

With Dodd-Frank, that becomes a business

decision.

And for the FDIC, it is a crucial decision.

Because in many of these structures, whether it be their

legal structure, their information systems, basically just

the structure of some of their products, if you make simple

decisions at the beginning, at the outset, we understand

some of the decisions that they are making at the outset,

not under a compressed time frame where we have to deal with

it in a weekend but actually going back when institutions

are making the decision we're going to buy, in the case of

Golden West, we want to buy, or Wachovia wants to purchase

it, we look at the structure and we're able to work with the

institution to make it I think more palatable for us to

absorb.

COMMISSIONER GEORGIOU:

just a second.

Let me focus on that for

Obviously Wachovia bought Golden West.

Right?

WITNESS CORSTON:

That's correct.

COMMISSIONER GEORGIOU:

Right.

And, you know,

Golden West was a monoline.

payment mortgages that we know people picked--when given the

They had these pick-your-

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1

option to pick a payment, they generally picked a lower one

than a lot of people would like, right?

even picked ones that resulted in negative amortization that

actually didn't even meet the interest, let alone the

reduction of principal on their payments, so their loans

just kept ballooning, and after time these are the kinds of

loans that caused problems not just at Wachovia but similar

types of loans caused problems at many institutions.

And sometimes they

Do you feel that you have the authority--does

anybody have the authority now to address a similar type

acquisition that will create within one of these larger

financial conglomerates that kind of focused risk that

helped to bring down Wachovia?

WITNESS CORSTON:

One of the keys in Dodd-Frank

is that when institutions have mergers or they structure

themselves in a certain way, we can look at those structures

seen through a living will process that, is it something

with which our corporation can deal?

can't, we have the ability to force divestiture.

And ultimately if we

It's something that--I mean, there are steps

along the way, but at least it provides the ability to

influence some of these structures to get the complexity and

the size to a manageable size for our corporation to deal.

And ultimately under the bankruptcy code is the

goal.

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CHAIRMAN ANGELIDES:

Two minutes.

COMMISSIONER GEORGIOU:

Thank you very much, Mr.

Chairman.

Let me just--I just want to highlight one point

before I turn to Mr. Alvarez.

most astonishing testimony that we have heard over the last

many months was testimony from the leadership, the CEO, the

chief risk officer, and the chief financial officer of

Citigroup who testified that they didn't know that certain

CDOs that were sold within their investment banking

And that is, that some of the

subsidiaries had a liquidity put provision that required

them to buy those CDOs back, which they ultimately exercised

in their $25 billion worth of CDOs bought back, which at the

time was one-third of the $75 billion of capital that Citi

had on its books.

In a similar circumstance, AIG's leadership

testified that they didn't know that there were collateral

calls associated with the credit default swaps that they

sold, that their Financial Products Division sold, that

required, when those tranches were downgraded, required

collateral to be put up.

or would have been the demise of the oldest and best-

capitalized insurance company in the history of the world.

Which of course led to the demise,

Are we presenting a problem now that is going to

be exceedingly difficult in the future to resolve without

bailing out institutions, by creating institutions that have

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so many diverse product lines and so forth within them that

they are exceedingly difficult to manage?

outliers?

Or are those just

I mean, to call Citigroup and AIG just an outlier

seems to me to be inappropriate.

have been central to our financial system for a very long

time.

8
9

They are central--they

So is part of the problem when these large
institutions are created that they are difficult to manage,

and they are difficult to supervise as well from the

regulatory perspective?

a difficulty that is going to be a problem in the future?

13
14
15
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17

And is that just setting us up for

Maybe Mr. Alvarez, just very briefly, if you
could just respond to that?

I've run out of my time.

CHAIRMAN ANGELIDES:

Why don't you respond, and

then we will go on.
WITNESS ALVAREZ:

That is an incredibly difficult

question and problem, but one way to think about it is Dodd-

Frank does put more responsibility on the agencies to ensure

that large organizations have enhanced requirements to deal

with risk management.

And there have been accounting changes that help

with the Citi problem and what they are responsible for and

not responsible for.

AIG fell in a gap in regulation.

There was no

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one who was supervising the top of the organization, which

does not relieve the management from its responsibility to

know what is going on, but may explain why there wasn't more

government pressure for the management to know what was

going on.

Those things I think they attempt to address in

Dodd-Frank.

going forward the tools that we have to deal with the crisis

are different than what they were up through 2008-2009.

I think another thing to keep in mind is that

The Federal Reserve will no longer have the

ability to make loans to individual specific institutions

like AIG.

put a requirement that we resolve these institutions by

wiping out the management and the shareholders, and

assessing losses across the creditors, and closing down the

institutions.

So that tool is taken away.

And in its place is

So the approach going forward will have to be

different.

prevent the problem, and more drastic solutions in the event

someone gets into trouble.

More regulation on the front side to try to

COMMISSIONER GEORGIOU:

Well we wish you Godspeed

in your work because this is extraordinarily important work

for the American People to implement this.

you to, in your analysis--I'm sure you're doing this--but to

try to bring in your analysis all the off-balance sheet

And I would urge

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exposures that all of these institutions had that rendered

them incapable, and their capital inadequate when crunch

time came.

holistically within the institutions and then systemically

across the board.

that authority by this new legislation, I urge you to use

it.

So you've really got to look at them

And to the extent you have been given

Thank you very much.

CHAIRMAN ANGELIDES:

Thank you.

Mr. Vice Chair,

you wanted to say something?

VICE CHAIRMAN THOMAS:

Yes, a brief 30 seconds to

Mr. Corston in terms of your answer to Commissioner Georgiou

about corporations looking to their bottom line.

FDIC do exactly that when on the 29th you unanimously

accepted a shared relationship with Citibank in the

acquisition of Wachovia by Citibank, and then two days later

when you were let off the hook by virtue of an unprecedented

Executive Branch usurpation of tax law provided an out that

really was a solution that better protected your bottom

line?

WITNESS CORSTON:

Didn't the

When I present my analysis to

our Board of Directors, I present analysis that shows the

least-cost and most protection to the Deposit Insurance

Fund.

that the exposure to the Deposit Insurance Fund was less

And my analysis showed, when we got the Wells offer,

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than that of Citigroup, and so it would ultimately be better

for us, or at least less risky.

VICE CHAIRMAN THOMAS:

So if I line up your

loyalty responsibility, it is to the FDIC first, and to the

American taxpayer second.

you, Mr. Chairman.

That's just what you said.

CHAIRMAN ANGELIDES:

COMMISSIONER HOLTZ-EAKIN:

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10

Thank

Mr. Holtz-Eakin.
Thank you,

Mr. Chairman, and thank you, gentlemen, for taking the time
to help us today to think about this issue.

I think it goes almost without saying that the

nature of government intervention into financial

institutions and markets is a signature of this particular

era, and one of the most controversial aspects of public

policy you could imagine.

It really does raise some questions that we have

to somehow answer.

the expectation of intervention, cause or exacerbate the

crisis that we have lived through?

question.

In particular, did the intervention, or

That's an important

For institutions that received it, what were the

criteria that were applied for who gets the help, how much

do they get, what form does it take?

thinking about the sort of notion of identifying those that

will merit intervention, what are the dimensions that

And in terms of

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policymakers are looking at?

Is it scale?

Large institutions get attention?

Is it interconnectedness?

may be deeply affected due to the failure of an institution?

Is it the business of being similarly situated?

allowing one institution to fail sends signals about others

that are similarly situated and thus exacerbates panic?

is it just the nature of market conditions that dictates the

need to intervene?

The fact that many counterparties

That

And these are all dimensions of the problem that

have been bandied about in our discussions in preparation

for this hearing, and I think I was asked to lead this

preparation in part because I have proven I don't understand

how to think about this problem.

So I wanted to start with you, Mr. Steel, and

just ask you:

financial market conditions evolve in the fall of 2007 and

into 2008, what institutions was the Treasury surveiling?

What criteria were applied?

largest?

measuring them?

During your tenure at Treasury, as we saw

Were you looking at the

Were you looking at counterparty exposures and

How was the Treasury thinking about this problem

and the systemic fallout from individual institution

failure?

WITNESS STEEL:

Well, when I reflect back at

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Treasury--and I was there from 2006 to 2008--that it really

was in the summer of 2007 when you saw the first cracks

start to appear.

related issues spread into securities markets.

began to have the reverberations into specific institutions,

is how I think about the process developing.

has their own image of this, but that's mine.

And basically what began with housing
And then

And everyone

I believe that there's no question that it was

tough to keep up with this situation as it was developing,

challenging; and that I think that our focus rolled along

with the phenomenon that I just described where there was

original focus on the challenges of housing and foreclosures

and what could we do to understand and try to be

constructive towards housing and focus on foreclosures.

Roman numeral two was, as this spread to the

securities markets, then it was really a matter of things

like the commercial paper market, and particularly asset-

backed commercial paper market.

And then you saw into monolines and also over-

arching this same period was great concern about the GSEs.

And so I think that was the leading up to the institutions.

And first with the securities firms, and then

into the commercial banks.

how we monitored and how we tried to follow the different

things, just from a time frame or the lens on how things

And that was the transition of

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lined up, sir.

COMMISSIONER HOLTZ-EAKIN:

So it is--I don't want

to put words in your mouth--is it fair to say you were then

looking at firms that were similarly situated as specific

markets became more impaired?

WITNESS STEEL:

Well I think we did our best to

also think about the interconnectedness, too.

Because when

you look at the effects on the monoline industry as it

spreads out to other areas, and what it means for securities

that are on the balance sheets of lots of other

institutions, all kinds, insurance companies, commercial

banks, securities firms, so I think it was really trying to

understand the interconnectedness and the institutions that

were affected by the situation we were examining as we

worked through those challenges.

COMMISSIONER HOLTZ-EAKIN:

But scale, per se,

didn't appear to be that important?

talk, it is not the size of the institution that matters.

It's other characteristics.

WITNESS STEEL:

And when I hear you

All kinds of things.

I think,

actually, as I tried to say, this began at I think the

grassroots level of trying to understand the effect on

foreclosures on homeowners.

then from there you had the ripples.

lie?

That was really the first.

And

And where does ABCP

And it turns out that if General Electric has a

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1

problem with ABC commercial paper, then asset-backed

commercial paper, that affects--and it also affects credit

cards; it affects student loans; and it affects all types of

securitized credit.

5
6
7

And so this was a phenomenon that went in lots of
directions.
COMMISSIONER HOLTZ-EAKIN:

So my understanding of

the Dodd-Frank legislation is that, as Mr. Alvarez said, the

nature of the intervention is now changed.

The Fed will not

be permitted to provide liquidity to individual firms.

it will and should stand up, as it did in this crisis,

facilities for which there will be broad eligibility for

liquidity assistance.

But

If that kind of facility is in place, and it's

getting commercial--asset-backed commercial paper, whatever

it may be, does that change the way we will have to worry

about the supervision of institutions and their systemic

implications?

broad-based liquidity to those markets?

20
21
22
23

Or have we taken care of that by providing

WITNESS STEEL:

I'm not sure I have a perspective

on that, to be honest.
COMMISSIONER HOLTZ-EAKIN:

Not even a guess?

guess all the time.

(Laughter.)

COMMISSIONER HOLTZ-EAKIN:

Sorry.

Let me turn to

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1

you, Mr. Corston.

You have been at the FDIC for a long

time, in fact long enough to have lived through FDICIA,

which is at least putatively supposed to have reined in the

FDIC's ability to assist large banks when they're in

trouble.

In your career, was there the sense that the 1991

law put handcuffs on you and raised the bar in terms of your

ability to provide FDI assistance to troubled institutions?

WITNESS CORSTON:

It certain narrowed the

options.

us a structure to work within, and it gave the industry a

structure to work within.

actually made things easier to implement.

structure there certainly were some constraints, also.

I think that with prime corrective action it gave

And I know as an Examiner that

COMMISSIONER HOLTZ-EAKIN:

But with that

So the decision to

provide the System Risk Exception in the Wachovia case was a

very important decision?

A precedent-setting decision?

WITNESS CORSTON:

Absolutely.

That was a very

unique situation, and obviously a very difficult one for our

Board to make.

COMMISSIONER HOLTZ-EAKIN:

So can you tell me a

little bit about the process for making that decision, and

what you looked at in Wachovia to identify it as

systemically important?

WITNESS CORSTON:

Sure.

At my level I deal with

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1

the examiners at the ground level, and am responsible for

producing information and analysis so executives or

directors at the Federal Deposit Insurance Corporation can

make decisions.

With regard to Wachovia, we knew that it had

credit exposure.

it provided some unique types of risks because it's

difficult to calculate the embedded risk in a pick-a-pay

portfolio when you really can't tell what is really a

nonperforming loan.

11
12

Certainly with the Golden West portfolio

COMMISSIONER HOLTZ-EAKIN:
Wachovia-specific risks.

WITNESS CORSTON:

COMMISSIONER HOLTZ-EAKIN:

18
19
20

Okay.
What are the systemic

dimensions--

16
17

But those are

WITNESS CORSTON:

The systemic dimensions when

we-COMMISSIONER HOLTZ-EAKIN:

--that you talked to

in--I mean, there was a memo, I'm sure, that set these down.
WITNESS CORSTON:

Sure.

As we got--worked with

Wachovia and we got to the weekend of the 25th, we had a

situation in a market that was very unstable.

institution that had a funding structure that was very

sensitive to the types of displacements that were taking

place in the market.

We had an

And we knew that it had this exposure.

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1

What we were not clear on was to the degree it

could impact the outside markets and other institutions.

were certain--

COMMISSIONER HOLTZ-EAKIN:

But you drew the

conclusion that it would, because that is the nature of

systemic risk.

WITNESS CORSTON:

Our analysis showed that there

definitely would be an impact.

significant.

And the impact would be

COMMISSIONER HOLTZ-EAKIN:

impacts be?

And what would those

measure them?

And how large would they be?

WITNESS CORSTON:

And how did you

As I mentioned before, these

are very difficult to measure and we were dealing in very

compressed time frames.

information.

So we're dealing with limited

But we did know we had very large institutions

also funded in a similar manner to Wachovia.

market was concerned about some of these institutions.

we knew that if something happened to disturb or give less

confidence to various counterparties at Wachovia, and they

could see what happened there, it could impact other large

institutions with which we may have to deal right after a

situation at Wachovia; and ultimately, it appeared, it could

freeze up the funding market.

We knew the

And that was an extreme

And

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concern.

COMMISSIONER HOLTZ-EAKIN:

So you viewed Wachovia

as being an indicator for similarly situated firms.

were others out there that looked like Wachovia, and if

people saw Wachovia go down they would draw the same

conclusions?

7
8

WITNESS CORSTON:

There

They had similar circumstances

as Wachovia.

COMMISSIONER HOLTZ-EAKIN:

same decision with Washington Mutual.

WITNESS CORSTON:

You didn't make the
Why not?

With Washington Mutual, the

structure, and especially the liability structure, was quite

different than that of Wachovia.

foreign deposit exposure.

They didn't have the same

They didn't have the same wholesale funding

exposure.

holding company.

products.

They didn't have a sizeable broker-dealer at the
They didn't deal in complex structured

So to measure the impact at Washington Mutual

which, while large, was really a large thrift that had

fairly simple funding structure, and it was far easier to

calibrate the collateral impact of that institution relative

to Wachovia.

24
25

COMMISSIONER HOLTZ-EAKIN:

And you didn't feel

the same concern that there would be other large thrifts

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1

structured like Washington Mutual that would come under

attack?

WITNESS CORSTON:

No, because essentially it was

the largest.

already.

funding they're not as sensitive to the funding market that

Wachovia was.

8
9
10
11

And we had dealt with some of the weakest ones

So--and again, because of the structure of their

COMMISSIONER HOLTZ-EAKIN:

Mr. Alvarez, the

Federal Reserve drew the same conclusion, that Wachovia was
systemically important for the same reasons?
WITNESS ALVAREZ:

Very much the same reasons.

And many of the things that you outlined.

it in more detail in my testimony.

has the memo that we used to analyze the Wachovia situation.

So you'll see that--I mean, it was the context.

And I presented

I believe the Commission

The economic situation was very important to

making the judgments about systemic risk of individual

institutions.

depository institution--third largest by deposits--so

incredibly difficult, large and interconnected.

The scale.

Wachovia was the fourth-largest

We looked at measures of interconnectedness, how

some--to the extent we could, where the commercial paper was

placed and the effect that not being able to pay commercial

paper might have on other institutions.

large exposures to different markets and different

Some of its other

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1

institutions.

The fact that it was well capitalized, considered

well capitalized, and the market didn't seem to see failure

of Wachovia coming, unlike WaMu where I think the market saw

that WaMu died over a long period of time and there was some

opportunity for folks to prepare for that.

The importance of Wachovia--

COMMISSIONER HOLTZ-EAKIN:

there should have been no intervention with WaMu?

10
11

So do you agree that

WITNESS ALVAREZ:

Yes, we agree that there should

not have been intervention in WaMu.

COMMISSIONER HOLTZ-EAKIN:

There are some who

assert that the failure of WaMu actually triggered a run on

Wachovia.

Do you agree with that?
WITNESS ALVAREZ:

I think that, as Mr. Steel

pointed out, the day after Wachovia--after WaMu failed, two

events occurred.

failed.

effect on Wachovia.

That was also the day that the legislation

And both of those things had a pretty dramatic

The question though I think isn't so much whether

it had a bad effect on Wachovia, but if we had stopped the

failure of WaMu, or aided in WaMu, would have have changed

circumstances with Wachovia?

there is much more doubt.

to have provided assistance to WaMu, that that would have

And I think that is where

It is not clear that, if we were

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1

prevented the problems that occurred at Wachovia.

2
3

COMMISSIONER HOLTZ-EAKIN:
balance of my time.

4
5

VICE CHAIRMAN THOMAS:

Do you want two additional

minutes?

6
7

I'll reserve the

COMMISSIONER HOLTZ-EAKIN:
back later.

No.

I'm going to come

Thanks.

Thank you, Mr. Chairman.

CHAIRMAN ANGELIDES:

Yes.

Thank you.

Actually, I just want to follow up on that one

comment.

that the expectation of government intervention is so baked

into the system that the two institutions that weren't

saved, Lehman and then WaMu, triggered panic in the system.

It does strike me that in this crisis it appears

It strikes me that, obviously in the wake of

Lehman there's tremendous panic and the government now has

to wade in with an $85 billion loan the next day.

this instance, WaMu is not saved and the run begins really

that afternoon and the next day on Washington Mutual.

And in

Which brings me back just to my original point,

which is it seems to me that it's so baked into the system

that the focus should have been, in the past and in the

future, on as the problem is growing, the risks are growing,

the institutional scale is growing, that's where the focus

needs to be.

Because when you get to the tail end and there

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1

is panic, there appears to be no viable option but rescue.

Is that a fair observation?

WITNESS STEEL:

I think that, yes, sir, the more

challenging the situation, the fewer options you have.

another way to think about it, which is constant with the

situation at Wachovia, was that as things became more

challenging, some of the planned alternatives became more

difficult to execute.

And

So, yes, sir, I think that prevention and a

better diagnostic approach in advance certainly gives you

more optionality on choices of paths.

CHAIRMAN ANGELIDES:

And it seems to me that if

you are going to have banks that are too-big-to-fail, then

you need regulators who are tough enough to handle those

banks of enormous scale.

Next would be Senator Graham.

COMMISSIONER GRAHAM:

Thank you, Mr. Chairman.

It seems to me that the key question here is, will there

continue to be the political support to do what has been

done in the past few months, which is the intervene at the

time of ultimate crisis.

Second, if that is suspect, that continuing

political support, what are the fundamental ways to avoid

reaching that point of extremis.

There are many Members--there are many candidates

87
1

this fall for Congress who are running on a platform of no

more bailouts, and are committing themselves not to support

programs like the TARP Program, should they be elected to

Congress.

Whether they will be a majority voice or not is

unknown, but that voice is certainly going to be louder in

the next Congress than it has been in the present Congress.

8
9

So if you assume that it is going to be more
difficult to come to the assistance, and if the consequences

of not coming to the assistance are as catastrophic as we

have described, then it seems to me it puts a particular

premium on figuring out how to avoid getting to that

extremis.

There are at least a couple of options:

One is that those institutions which have the

characteristics, whether they are size, complexity,

interconnectedness, similarity, sort of the herd effect,

should they be restrained somewhat like the Sherman

Antitrust Act was used to restrain the growth of large

industrial conglomerates at the end of the 19th and

throughout the 20th Century?

Or, can we have a regulatory system that will be

engaged at an early enough stage with these large, complex

institutions to avoid them getting into extremis?

What is your sense as to is it possible to

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1

control these organizations of this size and complexity in

their current form?

changing the system which has allowed these enormous

institutions to evolve?

Or will it necessitate fundamentally

I will start with Mr. Steel.

WITNESS STEEL:

Thank you, Senator.

I think you provided two choices, and I believe

that my perspective would be to support the second one.

And that is, that we can develop the right tools, capabilities,

so as to do a better job of regulating and managing these

10
11

important institutions.
I believe that the idea of a size limitation, or

interconnected limitation, or an importance limitation is

less realistic.

larger institutions in terms of product offerings, economies

of scales, and things like that.

the world is such that many of their competitors have these

characteristics.

There are benefits that come from having

And the global nature of

So my view would be to favor the second of the

alternatives you suggested.

whether it's a systemic perspective with regard to all of

these institutions, whether it's the idea of living wills,

or planning in advance with the regulators how a wind-down

would occur, and what are the stress points.

it's a matter of regulators, as Mr. Alvarez said, having

learned from the past and doing a better job going forward.

And I alluded earlier to

And whether

89
1
2

So that would be my instincts, sir, to the
question.

COMMISSIONER GRAHAM:

WITNESS ALVAREZ:

Mr. Alvarez?

I agree with Mr. Steel, I

think, and one of your early points, that it's going to take

regulators with strong backbone going forward.

going to be able to stop crises from occurring.

8
9

We are not

On the other hand, we can prepare ourselves
better for it and lessen the impact hopefully.

And one of

the ways to deal with that is by having strong regulation of

the large institutions that are complex to make sure they

assess the risk, they deal with the risk, they're prepared

for the risk in a better way than they have been in the

past.

I think also on the back end we are going to--we

are trying a new experiment now.

Reserve has not been, itself, happy with being in the middle

of providing assistance to some large institutions.

I think the Federal

My chairman has said that providing a loan to AIG

was one of the worst experiences of his life.

forward, Congress has reassessed the tools.

providing that kind of assistance anymore.

sends a message to the industry itself that, you know, the

idea that the Federal Reserve will be able to stand behind

you and provide liquidity if you get into trouble is no

And so going

We won't be
And I think that

90
1
2

longer present.
Now you have to confront, as management of an

organization, you have to confront the likelihood,

expectation, that if you're in trouble a new resolution will

be in your future.

6
7
8

So it does require a lot of work, strong work on
the front end.

And then a different look on the back end.

COMMISSIONER GRAHAM:

Someone mentioned that

there will be some 50 regulatory initiatives required to

fully implement the Dodd-Frank bill as it relates to this

issue of intervention at the time of crisis.

WITNESS ALVAREZ:

That's just 50 rulemakings at

the Federal Reserve.

agencies and what they have to do.

15
16
17
18
19

That doesn't count the other federal

COMMISSIONER GRAHAM:

Have any of those 50 been

implemented to date?
WITNESS ALVAREZ:

No.

We are just a little over

a month into it, but we have begun working in earnest.
COMMISSIONER GRAHAM:

Which ones do you think the

public should be most focused on as an indicator of whether

the Federal Reserve will use this authority with

sufficiently aggressive stance to avoid institutions in the

future getting into extreme trouble?

24
25

WITNESS ALVAREZ:

Well we will be seeking public

comment on our rulemaking, so we will invite comment from

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1

the public.

The ones that I think are going to be most useful

will be enhanced capital standards, enhanced risk management

standards, a provision dealing with living wills, provisions

dealing with the so-called Volcker Rule, the activities,

derivatives activities and other proprietary exposures that

can occur inside depository institutions and their

affiliates.

We also will be doing a rulemaking on our lending

authority and how it can be used in the future.

those I think will be of prime interest to folks worried

about dealing with the crisis going forward.

COMMISSIONER GRAHAM:

All of

Mr. Corston, you--excuse

me, it was actually Mr. Steel commented that while you were

still in the Treasury in 2007 you began to become concerned

that there were some warning signals.

correctly?

Did I hear that

Weren't there some warning signals before 2007?
We have heard, for instance, that in 2006 the

rate of acceleration of home prices started to slow, and by

the end of 2006 there were evidences of declining home

prices; that foreclosures started to go up in 2006; that

several of the subprime loan originators went bankrupt in

2006.

24
25

Those would all seem to me to be early warning
signals that something--that some steps needed to be taken

92
1

or we were going to be in the emergency room pretty soon.

And the fact that they were not taken I think got us to the

emergency room in the fall of 2008.

4
5

Why weren't those 2006 indicators enough to get
the Treasury activated?

6
7

CHAIRMAN ANGELIDES:
minutes to wrap up.

8
9

Mister--Senator Graham, two

WITNESS STEEL:

Well certainly there were, and

especially in hindsight, some signs that housing was having

some unusual activity, and that we were having challenges

start to appear.

I can tell you that at that time in 2006 and

early 2007 it was not our view that the prices would fall as

much as they later did.

significant decline in the asset prices that I think really

was the fuel to the situation.

And it was the subsequent

And so maybe we should have, or Treasury should

have, or I should have seen more things coming, but at that

time it didn't seem to have the trajectory that would take

it as far as it did, or be as pernicious as it turned out to

be.

COMMISSIONER GRAHAM:

Do you think, if what I

suggested that there's going to be an increased caucus that

says no more bailouts, no more TARP, will that cause the

Treasury and other regulatory and supervisory agencies to

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1

take a longer, or earlier look at what is going on in order

to reduce the chances of getting to the point where the

bailout would appear to be necessary, but may not be

politically available?

WITNESS STEEL:

To me, sir?

COMMISSIONER GRAHAM:

WITNESS STEEL:

Yes.

I would hope that would be the

case.

And I think Mr. Alvarez and I have shared--have

turned out to have similar perspectives as to what some of

those preventive steps might be, and whether it is stronger

supervision by regulators and supervisors, increased

capital, a systemic perspective with regard to risk, living

wills that anticipate how one would deal with a winddown.

Those are all the right types of things that I think could

be beneficial.

COMMISSIONER GRAHAM:

CHAIRMAN ANGELIDES:

Thanks.
Thank you, Senator Graham.

Mr. Hennessey.

COMMISSIONER HENNESSEY:

I think all my questions are for Mr. Alvarez.

could, they are actually about the other firm that we're

talking about on the next panel, about Lehman.

Thank you, Mr. Chairman.
And if I

So I was very interested in Mr. Fuld's testimony.

So if I could, since I have you here, even though you're

coming before him, I would like to ask you about the Lehman

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2

situation.
Your explanation before was very helpful about

secured versus unsecured loans.

Just to restate, as I

understand it the Fed can only make secured loans?

WITNESS ALVAREZ:

Correct.

COMMISSIONER HENNESSEY:

Collateral is one form

of security.

between the Bear Stearns situation and the Wachovia

situation is that there were both buyers available, and

But as I further understand it, the difference

there was security?

WITNESS ALVAREZ:

Correct.

COMMISSIONER HENNESSEY:

WITNESS ALVAREZ:

COMMISSIONER HENNESSEY:

Is that the basic?

That's basically--that's right.
Okay.

Now I've heard

numerous people say that the Fed chose not to act in the

case of Lehman.

There is an implication that there was a viable legal option

available for the Fed to prevent Lehman from going into

bankruptcy, and that the Fed chose not to take it.

I hear that over and over and over again.

I've heard the Chairman say differently.

In your

view, was there a viable legal option available at the time

to prevent Lehman from failing?

WITNESS ALVAREZ:

So there was no acquisition.

As you pointed out, there was no merger partner that came

forward to acquire Lehman, as there had been in Bear

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Stearns.

A very big difference.
I think that if the Federal Reserve had lent to

Lehman that Monday in the way that some people think without

adequate collateral and without other security to ensure

repayment, this hearing and all other hearings would have

only been about how we had wasted the taxpayer's money.

I don't expect we would have been repaid.

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9

And

That was not a situation the Federal Reserve
wanted to be in, nor could we be in legally.

perspective there wasn't a legal option.

So from my

well, I think that's the answer.
Okay.

It was of course--

COMMISSIONER HENNESSEY:

Now I want to ask

you a few things about Mr. Fuld's testimony.

VICE CHAIRMAN THOMAS:

Could I just--when you

said "Chairman," you were referring to the Chairman of the

Federal Reserve?

17
18

COMMISSIONER HENNESSEY:
correct.

19
20
21

Chairman Bernanke,

VICE CHAIRMAN THOMAS:

Okay, thank you.

For the

record.
COMMISSIONER HENNESSEY:

Yes.

In his written

testimony, a couple of things stand out.

written testimony for the next panel.

capital hole at Lehman Brothers.

And he said Lehman had

adequate financeable collateral.

Could you give your view,

This is Mr. Fuld's

He says there was no

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or your understanding of the Fed's view at the time on

either or both of those points?

WITNESS ALVAREZ:

So I think we believed on that

Monday that--let me separate out two things.

broker dealer, and there's the rest of the Lehman Brothers.

The broker dealer was a sizeable portion of Lehman, but the

rest of Lehman was also very large.

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9

There's the

We did in fact lend to the broker dealer through
the week afterwards as it was going towards bankruptcy and

the bankruptcy court then sold the broker dealer.

broker dealer itself had adequate collateral and only needed

a relatively small amount of funding.

But the

The parent of Lehman Brothers, though, in order

to operate, and from our experience with Bear Stearns, be

the guarantee of all its obligations going forward, its

liquidity had tremendously diminished.

capital, but its assets, the value of its assets was

declining rapidly.

with the company on any basis that didn't involve massive

amounts of collateral, which they weren't able to post to

deal with third parties.

It may have had

There were few people willing to deal

So third parties were not funding the

institution.

been to lend into a run of Lehman Brothers, at least so we

believed, and lead to its collapse.

For us to take on that obligation would have

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I can understand management would have a

different point of view.

save the company.

were trying to raise additional capital, and wanted more

time.

They were working very hard to

They had a plan to save the company and

It was just our estimation that we couldn't take

that risk.

couldn't move forward.

We weren't going to be in a secured position and

COMMISSIONER HENNESSEY:

Okay.

Good.

If I

could, I want to follow up on the distinction between

whether or not they were solvent and whether or not they

were liquid.

I understand the point that everybody was losing

confidence in them and Mr. Fuld's testimony suggests that

there were basically rumors going around, and that people,

including the Fed, had bad information about their liquidity

situation.

What I am trying to understand is:

Where they

actually solvent at the time?

were there assets greater than the value of their

liabilities?

bankruptcy report which suggest that there were valuation

issues, and everybody talks about everybody else losing

confidence, but when you look at their balance sheet, were

they solvent?

Apart from the liquidity run,

And I have gone through parts of the

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WITNESS ALVAREZ:

So I am a lawyer as opposed to

an accountant, so--

COMMISSIONER HENNESSEY:

understanding of the Fed's view at the time?

WITNESS ALVAREZ:

What was your

And I think actually, having

prepared for Wachovia and not reviewed the Lehman balance

sheet in awhile, I would rather, if you could, if you asked

that question to the next panel which is more prepared for

it.

COMMISSIONER HENNESSEY:

Okay, could I ask, could

you get someone at the Fed to give us something in writing

that describes what the Fed's view at the time was of their

solvency to the extent that it can be separated out?

WITNESS ALVAREZ:

Sure.

COMMISSIONER HENNESSEY:

Mr. Fuld talks about a

few actions that Lehman asked the Federal Government to do

that the Government did not do.

are a part of this answer as well, please jump in.

mentions three, specifically:

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21

And, Mr. Corston, if you
He

One is permitting Lehman to convert to a bank
holding company;

Two is granting Lehman's Utah bank an exemption

under Section 23(a) of the Federal Reserve Act to raise

deposits;

And then the third is a ban on naked short

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selling.

We'll skip that one.

Could you talk about either of those two?

WITNESS ALVAREZ:

So the notion of Lehman

becoming a bank holding company is one that Lehman explored

through the early part of the summer.

and costs.

Federal Reserve and all the regulatory burden that comes

along with that.

And it has benefits

One of the big costs being supervision by the

The problem I think turned out to be, at the time

Lehman wasn't certain of the benefits.

it would look like a gimmick.

any substance to it.

substance in--the real substance of the change to becoming a

bank holding company and the perception are very different.

It was afraid that

That it really didn't have

And in fact, I think that the

It is often thought that if a company becomes a

bank holding company it has greater access to the Federal

Reserve discount window.

additional access.

That's not true.

It gains no

What it does gain, though, is some of the

imprimatur from the Federal Reserve that it meets minimum

financial standards, and that it is now supervised in the

same way as other similarly situated bank holding companies.

But Lehman determined in the end that that wasn't

enough of a benefit to cause it to take on the burden, so it

didn't pursue that application.

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COMMISSIONER HENNESSEY:

If I could press you on

that, you're saying that Lehman decided not to pursue it?

Because his testimony says that they were not permitted to

become a bank holding company, suggests that it was a 'no'

from the Fed.

WITNESS ALVAREZ:

So there was never an

application filed by Lehman Brothers.

preliminary talks.

Lehman that they would not be able to pass muster.

There were

I know we at the Board did not tell
So, you

know, it's clearly a judgment management has to make.

Management has to be willing to pursue that option and deal

with the costs.

13
14

VICE CHAIRMAN THOMAS:

Would

you like an

additional two minutes?

COMMISSIONER HENNESSEY:

WITNESS ALVAREZ:

COMMISSIONER HENNESSEY:

WITNESS ALVAREZ:

Yes.

Then briefly on 23(a)-23(a).

23(a) would allow Lehman to

transfer some assets that could have been originated by a

bank but were not, were originated in the holding company,

it could transfer those into the bank.

loan company supervised by the FDIC.

It had an industrial

It sought some 23(a) relief, but I don't recall--

and John may have a better memory on this than I--that it

sought any significant 23(a) relief there.

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Of course one of the issues around 23(a) is:

Are

the quality of the assets being transferred to the bank

going to put the bank at risk?

FDIC.

the Federal Reserve and the FDIC, were very careful about

allowing institutions to transfer riskier assets into the

bank.

The bank is insured by the

That's direct taxpayer exposure.

So the agencies,

It is hard for me to believe that they would have

gained enough liquidity from transferring assets from Lehman

Brothers into the bank to have prevented the failure of

Lehman, perhaps delayed it some period of time, but I doubt

to solve the problem.

COMMISSIONER HENNESSEY:

Okay, if I could, just

in my remaining minute, his conclusion is, quote, "In the

end, however, Lehman was forced into bankruptcy not because

it neglected to act responsibly or seek solutions to the

crisis, but because of a decision based on flawed

information not to provide information with the support

given to each of its competitors and other nonfinancial

firms in the ensuing days."

Could you respond to that?

WITNESS ALVAREZ:

So I think I can agree with the

first half, but not the second half of that statement.

think the management of Lehman tried very hard to save the

company.

They raised capital in the Spring.

They attempted

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to raise capital again in the Summer. They have a plan that

they were in the process of implementing in September when

they failed that would have downsized the company, selling

off a bunch of assets and raising more capital.

management was trying very hard, and there should be no

illusions about that.

I think they failed not because the government

wasn't willing to help them, but because there was no--they

were a victim of the circumstance and the economy, and some

bad decisions that they had made through the years leading

up to that that they didn't have time to unwind or get out

of.

COMMISSIONER HENNESSEY:

And if I could, 30

seconds, his phrase, based on--or "because of a decision

based on flawed information," I believe means a decision by

the government based on flawed information.

with that?

WITNESS ALVAREZ:

Do you agree

I'm not sure what he's

referring to.

Our information flows are from Lehman, so I'm

not sure what he had in mind there.

COMMISSIONER HENNESSEY:

VICE CHAIRMAN THOMAS:

CHAIRMAN ANGELIDES:

VICE CHAIRMAN THOMAS:

Thank you.

Mr. Chairman?

Mr. Vice Chairman.
Mr. Alvarez, if we

provided you lunch would that be enough inducement to have

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you hang around for the second panel?

WITNESS ALVAREZ:

VICE CHAIRMAN THOMAS:

that one.

Um-You don't have to answer

I would like an answer to the next question from

actually all of the panel.

It's obvious that we're not going to be able to

ask and follow up on any number of questions that we would

have an interest in, and we will come to the conclusion

after the hearing, as we've done with each hearing, that

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11

there were things we would like to have asked.
Would all of you be willing to respond back to us

in writing if we send you some questions that we arrive at,

in writing, after this hearing?

WITNESS ALVAREZ:

Oh, most certainly.

WITNESS CORSTON:

It would be my pleasure.

WITNESS STEEL:

VICE CHAIRMAN THOMAS:

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19

Yes.
Thank you very much,

Mr. Chairman.
CHAIRMAN ANGELIDES:

Yes.

I'm going to go to Ms.

Murren, but one of the things, since Mr. Hennessey raised

it, I think what I want to do at this point is, it will be

the subject of the subsequent panel, but enter into the

record a chronology which has been prepared by our staff of

selected events related to Lehman Brothers and the

possibility of government assistance, if I could enter that

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2

into the record with its attachments.
And the only observation I make, and I think

we'll talk about it at greater length this afternoon, is--

and, Mr. Alvarez, maybe you may want to stay after lunch--

but I think it shows a relatively more complex picture.

I'm only going to make the observation that I did not, as I

said, see anything in the chronology where a legal opinion

was offered that would have stopped consideration of

financial assistance, nor a collateral analysis by the

And

Federal Government.

is a recognition of the systemic problems that can arise if

Lehman were to go bankrupt.

And what you do see in this chronology

You do see discussion about the fact that there

are tools and authority available.

assistance is being considered.

concerns about the bailout.

And clearly financial

You also see political

So what you see in this, it seems to me, is

obviously a complex situation you're trying to deal with.

And I am not sure at the end of the day, but we can examine

it in greater fullness, whether in and of itself the legal

bar was the sole constraint.

It looks as though there were a number of

considerations--political, financial--at work here.

a fair statement?

as far back as July, when there's consideration.

Is that

Because I never see, at some point even
For

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1

example, I think Mr. Dudley proposes a Maiden Lane type

solution.

legally possible."

4
5

I never see the Fed saying "can't do it; not

And it doesn't seem to me the collateral value
declines so precipitously in just 60 days.

WITNESS ALVAREZ:

So of course through--

CHAIRMAN ANGELIDES:

And I meant to hold this

till later, but you're here and I'll just ask that one

question before I go on.

10
11
12

WITNESS ALVAREZ:

You will also have experts on

Lehman this afternoon, and I think I will defer to them.
On the other hand, I can briefly add that we were

doing role playing contingency planning all through 2008

with all kinds of institutions to try to learn how to think

about these problems.

to actually act.

Because we very seldom had much time

And while it's often easy, and sometimes even

fun, to create a solution when the pressure isn't on, when

the facts are real and you understand really what your

constraints are, a lot of times those scenarios that you

dreamt up in the calmness of the summer aren't available and

don't work.

So we had a few of those.

And I think that it is

not surprising to me, as the person who has to write memos,

that on a weekend like Lehman we wouldn't have been able to

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1

write the kind of memos that you would like to see.

would like to have had the opportunity to write them, as

well, but it just didn't happen.

4
5

CHAIRMAN ANGELIDES:
till this afternoon.

I'll defer my questioning

Mr. Hennessey, you'd like a--

COMMISSIONER HENNESSEY:

Yes, just to engage on

this point here.

I'm not sure what your question is.

mean, what we've heard is that--is that his judgment is that

there wasn't a viable legal option.

write that down at the time.

Okay, so they didn't

busy weekend.

But as he's saying it was a

CHAIRMAN ANGELIDES:

It was more than the

weekend.

in the course of two to three months any expression in all

the communications about there being any legal bar.

And we can do it this afternoon, but I didn't see

COMMISSIONER HENNESSEY:

So is your question

about the legality of it?

whether or not there was sufficient collateral?

Or about the Fed's analysis of

CHAIRMAN ANGELIDES:

Whether that was the

decision, whether it was a more complex decision than just

we can't do it, legally.

COMMISSIONER HENNESSEY:

WITNESS ALVAREZ:

Okay, but if--

So I didn't mean to leave the

impression it was a simple and not a complex decision.

clearly was.

There were a lot of factors involved.

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CHAIRMAN ANGELIDES:

I mean, I guess, just to

answer Mr. Hennessey's question, there are two issues that

have been posited why we can't do this:

based on not enough collateral.

of in this chronology over two or three months is any focus

on the legal bar; and any focus on the government on the

inadequacy of the collateral.

8
9

the legal authority

And what I see an absence

Now maybe that came all together in the final
weekend.

COMMISSIONER HENNESSEY:

Right.

I understand.

And I guess what I'm getting at is, I'm not sure I

understand sort of the other variables, because at least my

experience at the time is if you don't have a legal option,

you don't worry about the other consequences of the other

aspects.

do.

You say, okay, that's not legal, what else can we

CHAIRMAN ANGELIDES:

That's what I'm questioning,

whether the legal constraint was really the bar here, or

whether in fact there was a conscious decision to allow

Lehman to fail, or a number of considerations that went into

the mix from political, to financial, to strategic, versus

just purely we can't do it legally.

at.

24
25

COMMISSIONER HENNESSEY:
more?

That's what I'm driving

Can I probe a little bit

I mean, we're hearing from the General Counsel that

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it was his judgment that it was illegal.

questioning whether that judgment was right?

that was actually how the decision was made at the time?

CHAIRMAN ANGELIDES:

Are you
Or whether

I think I'm questioning

whether that was the totality of the decision.

particularly in light of the March 2009 decision, which

seems to give the Fed enormous latitude.

8
9

And

So I'm just trying to get to what were all the
factors that went into that decision.

So--and again, we can

defer the balance of this for this afternoon, but that's

what I'm trying to drive to.

VICE CHAIRMAN THOMAS:

CHAIRMAN ANGELIDES:

COMMISSIONER HENNESSEY:

Mr. Chairman, 30 seconds?

Without a prejudgment.
I don't understand the

logic, but I won't press the point here.

VICE CHAIRMAN THOMAS:

Speaking of legal options,

I just want to put on the record a timely statement.

Because in an investigation by Richard Delmar, counsel to

the Inspector General of the Treasury Department, in the

action that was taken by Treasury on Notice 83, he concluded

there was, quote, "a legitimate argument that this

constitutes overstepping by Administrative action," and

coming from the IG of Treasury I consider those pretty

strong terms in terms of what they're allowed to say and not

to say.

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So I guess some folk were considering playing, or
coloring outside the box.

And in fact they did.

CHAIRMAN ANGELIDES:

COMMISSIONER MURREN:

Ms. Murren.
Thank you, Mr. Chairman,

and thanks to all of you for being here today.

I have a series of questions I would like to ask,

just to make sure I understand with some clarity what's been

said today, and also what we've read in your testimony.

It appears as though there really isn't a hard

and fast list of rules, or criteria, or measures by which

you determine if a firm is in fact going to pose a risk to

the system should it fail; and that oftentimes that that

determination is made not only based on the intrinsic

characteristics of the enterprise, but also the environment

that you're dealing with at the time.

things as investor, or market sentiment, which are very

difficult to predict and also difficult to handicap.

Would that be fair?

WITNESS STEEL:

COMMISSIONER MURREN:

And it includes such

Yes.
Yes.

With that in mind,

then, taking the new rules, you all seem to have gained a

lot of comfort with some of the new legislation that's

passed about the ability that you will have in the future to

be able to govern situations where firms may fail.

And I am curious about what would have been

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different if you were to apply the rules that we now have

today at the time when you were looking at situations like

Wachovia?

been different?

we had those rules instead of what we had at the time?

So then how would your body of knowledge have
And how might the outcome have differed had

Mr. Corston, if you could?

WITNESS CORSTON:

One of the important pieces is,

especially with complex institutions, is for our corporation

to reach outside the insured institution to be able to

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11

address affiliates and holding companies.
A lot of institutions have highly risky business

activities that take place across legal entities, so it

crosses--such as broker dealer operations that influence

banking operations also.

The ability to address an entity in total is,

from a practical standpoint, something you can actually

implement far easier in a complex institution than dealing

with a specific insured entity which is very difficult to

decouple from a holding company structure.

The really key piece is dealing with having the

ability to have a living will produced by an entity to

understand how they perceive they can be broken up, to be

able to influence some behavior and, from the decisions they

made with regards to being able to break up the entity, and

for us to be able to set up some resolution planning behind

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those, those legal--or the living wills provides a few

things.

It will provide kind of up-front time

information, and some influence over some of these

structures.

powerful tools for us.

So I think it does--it does provide some fairly

COMMISSIONER MURREN:

So then if you were to have

applied those tools in the past at Washington Mutual or at

Wachovia, how would it have been different?

WITNESS CORSTON:

Well, dealing with Wachovia we

had a broker dealer outside the institution.

to understand the interconnectedness of the broker dealer

not only with the insured institution but with the various

counterparties.

The ability to,

So the ability

under our qualified financial

contract rule, to be able to get an understanding of all the

interrelationships, financial contracts, ahead of time; and

understand the magnitude of these various contracts would be

a tremendous help.

And then also looking at the structure, and

understanding that the ability to work the holding company

through the bankruptcy code, as well as the insured entity

and the impact and interconnectedness of both, and to plan

for that would be a tremendous help.

COMMISSIONER MURREN:

So then the outcome might

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not have differed, it just would have been a little bit

easier as you went along?

WITNESS CORSTON:

It might not have differed, but

it certainly would have been--I think we would have made

much more informed decisions.

COMMISSIONER MURREN:

WITNESS ALVAREZ:

Thank you.

Mr. Alvarez?

So I agree with what

Mr. Corston has said.

We would have been able--some of the

handcuffs would have been taken off on our supervision.

would have had more enhanced capital risk management,

liquidity, and other requirements.

something that we'd be exploring, and that would be

something that we hope in a crisis will be a useful tool.

Living wills, definitely, to prepare for a crisis.

Contingent capital is

I think the greater effect of Dodd-Frank, though,

would be in the other institutions that we've been

mentioning today:

Those institutions I think would have been subject to higher

capital requirements, more liquidity, better supervision,

They would have had supervision.

supervisory regime.

AIG, Bear Stearns, Lehman Brothers.

Many of them had no

And so hopefully it would have--we wouldn't have

gotten into this cycle that so many Commissioners have been

worried about about starting to, you know, help an

institution, Bear Stearns, and create the moral hazard that

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goes along with providing government assistance, and the

expectations that that creates for other large institutions.

If we could break that cycle, I think we end the

too-big-to-fail, as it were.

deal with a Wachovia, more natural to deal with a Wachovia,

and hopefully less stress on a Wachovia.

Then that makes it easier to

COMMISSIONER MURREN:

And also, from what you

said then, some of the other firms would have been in a

better financial position and might not have failed?

WITNESS ALVAREZ:

Or if they weren't in a better

financial position, would have been put into liquidation.

That's right.

COMMISSIONER MURREN:

Thank you.

Mr. Steel, if

you could comment on the financial position at Wachovia,

applying again the rules that we have today backward, would

the company's financial position have been dramatically

different from what you can see?

WITNESS STEEL:

Well I think if you--if we take

the prism that's been suggested as part of the new

regulation, certain parts of it certainly would have been

constructive with regard to how Wachovia ran its business.

In particular, those things that I previously

described as good-health type activities:

regulation; more engaged regulators and supervisors; living

will for planning for resolution.

stronger

I think it's very

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difficult and early to say with specificity what differences

might have been, given the fact that so many of the rules

related to this legislation have not yet been written.

And so I find that a bit of a leap that's

uncomfortable, but I think that there's no question that a

more robust regulatory supervisory regime, and a tighter

lens on potential capital, would be positive.

COMMISSIONER MURREN:

Thank you.

I've exceeded my time, Mr. Chairman.

CHAIRMAN ANGELIDES:

Ms. Born.

COMMISSIONER BORN:

Thank you, Ms. Murren.

Thank you, Mr. Chair.

have heard a great deal on this Commission about how

interconnections among financial institutions played a role

in the government's decision to rescue institutions, or

provide extraordinary government assistance.

And all of our largest commercial bank holding

companies and investment banks were among the world's

largest over-the-counter derivatives dealers at the time

they received extraordinary government assistance, as was

AIG.

There were millions and millions of these

transactions in existence in mid-2008.

amount of over $680 trillion.

were bailed out had extraordinarily large concentrations of

They had a notional

Most of the institutions that

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these very large positions of these instruments.

And I

wanted to ask whether or not the derivatives positions of

the institutions played any role in your agency's

consideration of whether they should be rescued?

And maybe we should start with Mr. Alvarez.

WITNESS ALVAREZ:

So most certainly AIG, the

derivatives activities there, were a key factor in measuring

both the risk to the institution and the interconnectedness

of the institution.

I think derivatives for all institutions were one

of the things that we looked at to understand the

connections between an institution and others in the

marketplace and its exposure, the result of whether an

institution's failure would have ramifications broadly in

the system.

16
17
18

Derivatives are one way of transmitting that kind
of risk, as you are aware.
But with AIG in particular, they had a sizeable

book of unhedged derivatives exposure that posed tremendous

risk to them.

of the sources of their financial difficulties, and the size

of the book showed interconnections throughout the world

with major institutions and governments and municipalities

here in the United States as well.

It was collateral calls on that that was one

So it was a big indicator of the risk of that

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institution failing.

COMMISSIONER BORN:

Did the Federal Reserve have

information on the derivatives interconnectivity of all

these institutions?

WITNESS ALVAREZ:

No, we did not.

And that is a

big gap in understanding the systemic effects of

institutions, and one that I think the Dodd-Frank bill makes

great strides to remedy.

COMMISSIONER BORN:

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11

WITNESS ALVAREZ:

How will it do that?

It will do that in a couple of

ways.

It creates the authority in the CFTC, the SEC,

and the Federal Reserve to collect information about

derivatives' exposures.

derivatives at central counterparties.

organized central counterparties, which we think will reduce

the risk.

It also requires more clearing of
And strongly

The Federal Reserve also, as I'm sure you're

aware, was involved several years ago in trying to have the

industry commit more of its derivatives' exposure to paper

in a more regularized way, and keep track of that.

Dodd-Frank takes another step in encouraging

warehouses that will keep the information about contracts,

and when they're due, and their various terms.

a number of steps I think to improve the resilience of that

So it takes

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part of the market.
COMMISSIONER BORN:

Mr. Corston, is this a issue

that the FDIC looks to in, number one, considering systemic

risk; but secondly, in the process of resolution of a

failing institution?

WITNESS CORSTON:

It's extremely important.

And

I think one of the most important pieces of it is the

transparency of the derivative positions in the contracts.

And, as Mr. Alvarez has suggested, some of that is being

10
11

dealt with.
But for us as a deposit insurer, our ability to

understand these positions, the risk characteristics, and

know them quickly is very important.

COMMISSIONER BORN:

How does the FDIC handle the

derivatives portfolio of a commercial bank when it fails,

and the FDIC undertakes resolution?

WITNESS CORSTON:

Not an area I directly deal

with, but essentially the FDIC has to look at financial

contracts and to determine whether a very short window, 24

hours, whether they want to keep a contract or not.

So our ability to understand really the position

on a contract and whether it's advantageous to the receiver

or not is very important.

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COMMISSIONER BORN:

Of course over-the-counter

derivatives were deregulated in 2000 with the Commodities

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Futures Modernization Act, and I'm sure that that made it

more difficult for the agencies to have an understanding of

the marketplace and to have the information about exposures

of various institutions.

Mr. Alvarez, in your discussions with the

Commission staff you've talked about the role that

deregulation played in the marketplace, and perhaps in

making the marketplace more fragile and exposed to the kind

of crisis we had.

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Do you think that deregulation was a

factor?
WITNESS ALVAREZ:

Well I do.

I think that there

was a strong press for deregulation through the late '90s

and most of the 2000 period, and I think that weakened both

the resolve of the regulator and the attention paid by

institutions to the risk management that it should have--

that the institution should have had.

Regulatory burden is important to watch.

It is

something the agencies need to be mindful of, particularly

as it applies to small institutions, but the regulatory

reduction we were doing across the board I think weakened

our resolve at larger institutions, which was a mistake.

COMMISSIONER BORN:

I would like to place in the

record the transcript of Mr. Alvarez's interview with our

staff on March 23, 2010.

Thank you.

CHAIRMAN ANGELIDES:

Thank you.

Mr. Wallison.

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COMMISSIONER WALLISON:

Thank you, Mr. Chairman.

And thank all of you for coming, and for the service that

you all have done for our country over many years, and

especially through the very difficult times you experienced

in 2008.

I would like to turn attention to something that

we haven't discussed here, and that is the decision to

rescue Bear Stearns.

sin, because everything changed after Bear Stearns was

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To me this was in effect the original

rescued.
Among other things, participants in the market

thought that all large firms, at least larger than Bear

Stearns, would be rescued.

believe they had to raise as much capital as they might have

needed because they probably thought they didn't have to

dilute their shareholders because the government would

ultimately rescue them, and fewer creditors were going to be

worried about their capitalization.

Companies probably did not

The Reserve Fund probably did not think it had to

eliminate from its balance sheet the commercial paper it

held in Lehman because it thought Lehman would probably be

rescued and it wouldn't have to suffer that loss.

Potential buyers of, say, Lehman probably thought

they were entitled to get some government support, since the

buyer of Bear Stearns, JPMorgan Chase, got government

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support.

that he thought Lehman would be rescued.

likely to drive a much harder bargain with potential buyers.

And finally, Lehman itself has said, Fuld has said
And so he was

So the decision on Bear Stearns was exceedingly

important in analyzing this entire process.

Mr. Steel, you were both I think probably involved in that.

And I would like to get your thoughts.

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Mr. Alvarez,

First of all, one of the things that flowed from
Bear Stearns was the question of moral hazard.

And I would

like to know whether in consideration, when you were giving

consideration to whether to rescue Bear Stearns, any thought

was given to the question of moral hazard, what that would

do to the market in the future?

And secondly, since now regulators are expected

to consider systemic issues when they examine or otherwise

supervise financial institutions including nonbank financial

institutions, I would like you to give us some indication of

what you think a systemic risk is and how, apart from the

circumstances at the moment, you would be able to define

"systemic risk."

So if I may, can I start with you, Mr. Alvarez?

WITNESS ALVAREZ:

Certainly.

So yes there was

consideration given to moral hazard.

things that actually I think made the decision at Bear

Stearns and each of the decisions after that either to help

It was one of the

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or not to help an institution very difficult for members of

the Board of Governors.

They were very worried about moral hazard, very

worried that they would be viewed not as simply a lender of

last resort but as the support for everyone.

I think that is one of the reasons that you see

in the leadup to Lehman so much discussion about how there

will be no government assistance, and Hank Paulson,

Secretary Paulson at the time, in particular saying that

there would be no government assistance, in part to try to

negate the moral hazard that had been created by Bear

Stearns.

It was also one of the reasons that the Chairman

of the Fed, Chairman Bernanke, began calling for a

resolution regime, because he needed and felt that we needed

a more certain way to pass on losses to the shareholders, to

replace management, to try a different avenue.

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So moral hazard is something that we were very
worried about in all of our situations.
COMMISSIONER WALLISON:

So if I can interrupt,

why then did you decide, to the extent that you can

recapitulate everything that was on the plate at the time,

why did you decide, given the consequences for moral hazard

to which you were so sensitive, to rescue Bear?

WITNESS ALVAREZ:

Because we thought at the time

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that if we didn't provide assistance to allow a merger of

Bear, that--and I think we view that a little differently

than a "rescue"; we facilitated the sale of Bear Stearns--

that if we hadn't done that and Bear Stearns had collapsed

at that point in 2008, the cost to the system would have

been much greater than the cost of the moral hazard going

forward.

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COMMISSIONER WALLISON:
decision?

How did you make that

What "costs" were you considering?

you actually add up all of those costs?

And how could

in mind?

WITNESS ALVAREZ:

What did you have

I appreciate it's not, as has

been probed today, there's no single number, or even a

series of numbers that you can add up and be certain about.

There's a lot of judgment involved.

you recall, the financial system was under severe stress.

The Recession had begun.

But in early 2008, if

There was the various

indicators of market activity that were showing that markets

were closing.

term.

that point, while the SEC's rules are based on the idea of

liquidity based on collateralized borrowing, it never

occurred to the SEC that there could be borrowing or even

collateral wouldn't be sufficient.

that the broker dealers found themselves in at the time.

Funding was becoming shorter and shorter in

In fact, I think Chairman Cox had testified that at

And that's the problem

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So we were worried about a collapse of Bear,

Lehman, Goldman, Merrill Lynch, all right in a row at that

period of time and the consequences of that.

COMMISSIONER WALLISON:

And you were able to

assess those as very likely to occur?

WITNESS ALVAREZ:

We were--so we were very

worried that they would occur.

that we provided in connection with an acquisition of Bear

Stearns would be repaid so that the Taxpayer, while subject

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We thought that the loan

to risk, would not actually take any losses.
It was the tool that Congress gave us to deal

with these kinds of situations.

potential that we had a tool, didn't use it, there was a

horrible effect, and the Federal Reserve stood by.

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So we also had to face the

So weighing all those together, we decided to
provide the credit.
COMMISSIONER WALLISON:

Mr. Steel, could you

provide any further information about what was in your mind?

You were at the Treasury at the time, and probably the key

official at the Treasury, other than the Secretary, who was

concerned with issues of this kind.

WITNESS STEEL:

Well I think that you're right--

you're correct to suggest, as you did in your opening

comment, that this in a way set us on a path that became

increasingly challenging to manage, point one.

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Point two, there had been entreaties earlier that

year for government to get involved with weaker financial

institutions, which we had chosen not to respond to.

Monolines, other things like that.

and they recapitalized themselves, and their business model

changed.

And the markets worked,

This was an especially difficult one for me.

you suggested earlier, I had spent almost three decades in

the securities industry, and I viewed that securities firms

were different than depository institutions.

my career I had seen people be successful, and people be

unsuccessful, and the freedom to fail was part of the

dynamic that characterized this segment of the financial

services industry.

As--

VICE CHAIRMAN THOMAS:

And that over

I yield the Commissioner

an additional two minutes.

COMMISSIONER WALLISON:

WITNESS STEEL:

Thank you.

Excuse me.

As Mr. Alvarez said,

I think we drew a distinction--again, maybe it's too fine,

but I think it's with a difference, or it was interpreted as

a difference--that facilitating a merger with a loan that we

fully expected to be repaid--or excuse me, the Fed fully

expected to be repaid, because it's their decision--was

appropriate, given the dynamic.

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And there was, if my memory is correct, the PRI

of Bear Stearns in the previous 12 months was 169-3/8ths,

and when this transaction was going to occur, the original

proceeds were $2.

without any pain, the company would change management,

management would be--from Bear Stearns would leave; the

shareholders would pay a significant price; and so the

bridging to Bear Stearns with this loan seemed to be

appropriate at the time.

And so the idea that this was done

COMMISSIONER WALLISON:

But with all respect, the

issue was not money here.

raise is the moral hazard consequences of going ahead with

Bear Stearns.

be paid back is not as significant as the fact that the

creditors were actually rescued here and would, from that

point on, have a completely different attitude toward what

the government was going to do in the future than they might

have had before Bear.

The issue I've been trying to

So the fact that the government was going to

WITNESS STEEL:

There's no question that that

point is correct and fair.

certainly we discussed this moral hazard issue.

the benefit of hindsight and all the other things that

happened subsequently, then you have to probe at this

perspective to think about this.

I didn't say in my answer that

COMMISSIONER WALLISON:

And given

Thank you for the

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additional time.

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I will have other questions later, if there is
time.

CHAIRMAN ANGELIDES:

Mr. Thompson.

COMMISSIONER THOMPSON:

Thank you, Mr. Chairman,

and welcome gentlemen, and we do appreciate all of what you

do for our country.

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What is clear is that there appears to be no
formulaic approach to dealing with too-big-to-fail.

There

is no standard approach by which you can calculate or

determine whether or not an entity falls into that category.

So it is very judgmental.

What is also clear from not just comments made by

you but comments made by Chairman Bair and Chairman Shapiro

was that this was in fact a huge--my word not theirs--

failure in supervision, where in fact had some things been

done on the front end we might have mitigated the crisis

that we are now suffering through as a country.

Yet, each of you--at least two of you--have said

that the Dodd-Frank Act has the potential to change the

world and make things much better for our country the next

time around.

So why are we, as Commissioners, or the American

People, to believe that supervisory failures won't occur the

next time around?

That the Dodd-Frank bill may set some

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foundation for what regulations are going to be put in

place, but we will fail once again to implement those

regulations in practice?

Mr. Alvarez?

WITNESS ALVAREZ:

So I think that supervisory

failures come in two categories.

result of regulators not doing their job well enough, and

there's all of us who realize we could do our job better,

and we want to do our job better.

There's those that are the

But there are also supervisory, regulatory,

statutory gaps.

no matter how much we wanted to do them.

I think the Dodd-Frank bill is most important.

There are things that we just could not do
And that is where

It plugs a bunch of supervisory gaps.

authorizes the regulators to look at all systemically

important institutions.

It authorizes us to take a systemic approach to supervision.

Before we were constrained to taking a micro view of the

safety and soundness of particular institutions.

That authority didn't exist before.

So it takes off some handcuffs that were put on

during the period of regulatory burden reduction to keep the

regulators from doing too much in the supervision and

regulation.

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So all of those I think are important
improvements to our ability to do a better job on the

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supervisory front.

I agree that there is no way to be certain that

the regulators will get everything right, or do our jobs

perfectly going forward.

management of institutions.

management and how they deal with it, that's their

responsibility as well and they have to deal with that

better.

So there has to be changes at
Their focus on their own risk

Investors have to do a better job of paying

attention to what they invest in, not simply rely on a

rating of somebody they don't know about an instrument they

don't understand when they put that in their portfolio.

So there is blame to go all the way around.

And

while we deserve our part, and we'll deal with our part, I

think for us to deal with a crisis more successfully going

forward, everyone is going to have to chip in and do a

better job than we did leading up to 2007.

COMMISSIONER THOMPSON:

WITNESS CORSTON:

Mr. Corston?

I think to add on to those, it

broadens the focus to systemic issues and which the

individual agencies didn't necessarily have a clear

perspective on.

It recognizes that as these institutions have

gotten larger and complex, it isn't just an insured

institution in our case, but you're looking at holding

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company structures which you're going to have to address.

And it also addresses the issue, the fact that, given the

size of these institutions, there's upfront work that needs

to be done with regard to establishing the living will

process.

COMMISSIONER THOMPSON:

Well no one wants to be

the person that turned the lights out on the party, and

there was a big party going on here called the bubble.

what changes have to happen in the management of the

And

regulatory organizations such that they're willing to step

up and turn the lights out?

(Pause.)

WITNESS ALVAREZ:

So I--I'll take a start.

think the most--it's very hard to identify bubbles when

they're happening.

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You don't know if it's--

COMMISSIONER THOMPSON:

This one was pretty

apparent to everyone, wasn't it?

WITNESS ALVAREZ:

Well, I think--I think there

was a real debate about whether this was--whether there had

been a repeal of the business cycle and housing prices could

go, increase for a long period of time and be sustainable,

or whether there was to be an end.

And where the end would be was very much subject

to debate.

when the punch bowl needs to be pulled away, the most

But I think, given the difficulty in identifying

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important thing we can do is to try not to set the

conditions for the creation of a bubble.

So as a supervisor we think about making sure

that institutions identify the risks that they're taking on,

and how they are going to address those risks and reduce

those risks.

how the risk affects them, but how the risk affects others

in the market that they're dealing with.

Making sure now that they understand not just

So as an example, the originate-to-distribute

model for mortgages was, from a very narrow point of view of

a bank supervisor looking at safety and soundness, a very

good approach.

originating mortgages, helping the housing market, but not

taking on the risk of those mortgages, selling them to

investors who understood the risk and dealt with the risk.

Because banking institutions were

Well as it turned out, they didn't understand the

risk.

institution originating it wasn't taking on risk directly,

it was creating weakness in the system that reverberated

back on the institution itself.

They weren't dealing with the risk.

And while the

Being able to have a systemic point of view about

risk allows us to take steps to address those kinds of

models, and hopefully identify them in advance, have the

underwriting standards in this case improved, and perhaps

take steps for investors to pay more attention to the risk.

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So it allows a different perspective.

hopefully in that way allows us to reduce the conditions for

bubbles so that they won't be as large.

And

I don't think there is anything we can do to

prevent them all, or to identify everything in advance, and

to prevent a crisis, but we can certainly do more now than

we could before.

COMMISSIONER THOMPSON:

WITNESS STEEL:

Mr. Steel?

I don't think I have anything

additional to add.

that we are going to have regulation that will be perfect,

and that we will not catch anything, or that--I just don't

think that is realistic.

as to how to think about how bubbles develop, and behavior

develops, and then to do as much as you can to have the

institutions take on more responsibility.

Mr. Alvarez said, you have lots of responsibility by lots of

different parties that wasn't discharged as we would wish.

I think that I would be unoptimistic

So the idea of planning in advance

And I think as

And it basically goes with regulators.

with managements.

with Congress.

could have been more perceptive, more honest, and more

forward thinking about these things.

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It goes with individuals.

It goes

And it goes

And they're all examples where everyone

COMMISSIONER THOMPSON:
Thank you, Mr. Chairman.

Thank you very much.

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VICE CHAIRMAN THOMAS:

Mr. Chairman, I want to

associate myself with the "take the punch bowl away"

position of Mr. Alvarez.

lights, there was a whole lot going on in the dark.

Because if you turn out the

(Laughter.)

VICE CHAIRMAN THOMAS:

problems that we wound up having.

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CHAIRMAN ANGELIDES:
at the appointed hour.

And that was one of the
So pull the punch bowl.

All right.

I think we are

Noon, straight up.

So I want to

thank this panel.

Are there any additional?

(No response.)

CHAIRMAN ANGELIDES:

this panel--one question, Mr. Wallison?

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All right, I want to thank

COMMISSIONER WALLISON:

I'd like to ask one or

two.

CHAIRMAN ANGELIDES:

Well why don't you ask one,

and then we'll wrap on down.

And Mr. Thomas has another--

Mr. Thomas, do you want to yield that?

VICE CHAIRMAN THOMAS:

CHAIRMAN ANGELIDES:

wrap up.

Oh, sure.

Another minute, then we'll

it to bed.

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Why don't we do one question, and then we'll put

COMMISSIONER WALLISON:

I have so many questions.

This question I think is for Mr. Corston.

We've looked at

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Citi, and at the time we looked at Citi it looked like a

pretty weak institution in 2008.

much between--after 2008, a little bit.

that is bothering me is:

Citi, which we near insolvency itself as many people said,

to pick up another institution that was also weak in the

form of Wachovia.

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It didn't seem to improve
But the question

The FDIC approved the idea of

I don't understand how that decision could have
been made.

What was in the minds of the people at the FDIC

who unanimously agreed to do that, to take an already large

and seemingly confused institution like Citi and graft onto

it another institution that the market had already concluded

was, if not insolvent, at least in seriously illiquid

conditions?

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Can you explain that?

WITNESS CORSTON:

That's a great question.

When

we-CHAIRMAN ANGELIDES:

See if you can explain it in

30 seconds--no.

WITNESS CORSTON:

I'll do 30 seconds.

CHAIRMAN ANGELIDES:

WITNESS CORSTON:

As quickly as you can.

When you look at Wachovia, and

you look at Citi, Citi had a largely wholesale funding

structure and not a very large retail deposit base.

Wachovia had was a fairly decent retail franchise, albeit

with some wholesale funding and certainly some baggage that

What

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would have gone along with it.

The thought was, to be able to incorporate the

two would allow to stabilize some of the funding structure

at Wachovia and add some core funding structure at Citi at

the same time.

some financial weaknesses, but there were some synergies

that actually could--they could grow off of and actually

build some strength within them.

concerns are very well--

So it's taking two institutions that had

COMMISSIONER WALLISON:

VICE CHAIRMAN THOMAS:

But certainly your

Thank you.
Mr. Chairman, to conclude

once again, when we said that we should take the punch bowl

away and it would be the regulators who took it away, we

meant that you were supposed to dump it out and now continue

the consumption at the regulation stages.

a question that we would be very concerned about.

course you were relieved of it by Treasury/IRS making a

decision which I think was frankly outside the bounds.

think I said that.

CHAIRMAN ANGELIDES:

I think that was

Yes, you have.

All right,

members.

Members of the Commission and the public, we will come back

here at 12:25, a little behind schedule but close enough to

catch up.

Thank you very much, panel members.

But of

And to the

(Whereupon, at 12:05 p.m., the Commission meeting

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was recessed, to reconvene at 12:28 p.m., this same day.)

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AFTERNOON SESSION

(12:28 p.m.)

CHAIRMAN ANGELIDES:

The meeting of the Financial

Crisis Inquiry Commission will come back into order.

now going to start session two for today as part of our

hearing on institutions that are too big or too important to

fail.

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9

We are

This afternoon's panel is about Lehman Brothers.
I want to welcome the panelists.

Thank you for coming here

today.

We will start today's proceedings, as we always do,

by asking all of you to please stand up to be sworn in.

if you would please raise your right hand, and I'll read the

oath:

perjury that the testimony you are about to provide the

Commission will be the truth, the whole truth, and nothing

but the truth, to the best of your knowledge?

And

Do you solemnly swear or affirm under the penalty of

MR. BAXTER:

I do.

MR. FULD:

MR. MILLER:

I do.

MR. ZUBROW:

I do.

(Panelists sworn.)

CHAIRMAN ANGELIDES:

Thank you very much,

gentlemen.

we look forward to your oral testimony.

We thank you for your written testimony, and now

To each of you, we are asking that each of you

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speak for up to five minutes.

As I indicated earlier this

morning, in front of you will be a set of lights.

there's one minute remaining, the green light will turn to

yellow.

if you would turn your microphones on when you do give your

testimony.

When

And then at five minutes it will turn to red.

And

And with that, since I went left to, my left to

my right this morning, I am going to go the other way this

afternoon, just to show the amazing nonpartisan, bipartisan

nature of this Commission, and I am going to start with Mr.

Zubrow and ask that you open the testimony today.

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WITNESS ZUBROW:

Thank you very much, Chairman

Angelides, Vice Chairman Thomas, Members of the Commission:
My name is Barry Zubrow.

I am the Chief Risk

Officer of JPMorgan Chase, and have served in that role

since I began working for the bank in December of 2007.

Thank you for the invitation to appear before the

Commission today.

topics related to JPMorgan, including our triparty repo

program generally, and our relationship with Lehman Brothers

in particular.

You have asked me to address several

JPMorgan is one of two major banks providing

triparty repo clearing services in the United States, and we

serve as triparty agent for Lehman's broker dealer

subsidiary.

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At the beginning of each trading day in a process

known as "the unwind," JPMorgan would advance Lehman the

cash needed to buy back securities Lehman had sold to

investors the night before.

discretionary and meant to be fully collateralized by the

securities being repurchased.

These advances were entirely

On a typical day during the summer of 2008, these

advances exceeded $100 billion daily.

As of late 2007,

JPMorgan generally took no margin, or "haircut," on these

large discretionary loans we made to Lehman each morning.

This magnified the risk that JPMorgan would be

unable to recoup the full amount of our advances if the

collateral had to be liquidated.

Federal Reserve, shortly after the near-collapse of Bear

Stearns in March of 2008, we began taking margin on the

interday advances made to all of our broker dealer clients.

I consultation with the

In addition, JPMorgan executives held a high-

level meeting with Lehman in June of 2008 to discuss the

unique risks we faced from the unwind, and the interday

extensions of credit to Lehman, and identified a multi-

billion dollar collateral shortfall.

Lehman executives agreed to pledge additional

collateral to JPMorgan then in the form of securities.

late August and early September 2008, Lehman's deteriorating

financial condition was becoming increasingly apparent.

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Nevertheless, we were determined to support Lehman by

continuing to unwind the triparty repo book each morning and

otherwise acting on a business-as-usual basis.

But our growing exposure to Lehman also included

derivatives transactions for prime brokerage clients, and

requests by Lehman's derivative counterparties for

novations.

JPMorgan and Lehman understood that Lehman's

credibility in the markets could collapse instantly if

JPMorgan declined to take on this additional exposure.

To protect ourselves without triggering a run on

Lehman, we requested $5 billion in additional collateral, an

amount which was far from sufficient to cover all of our

potential exposure to Lehman, but that we believed Lehman

could reasonably provide.

On September 9th, Lehman agreed to pledge

additional collateral and delivered approximately $3.6

billion over the next few days.

around September 11th of 2008 indicated that some of the

largest pieces of collateral that Lehman had pledged were

illiquid, could not reasonably be valued, and were supported

largely by Lehman's own credit.

An analysis performed

This was inappropriate collateral because it was

essentially claims against Lehman pledged to secure other

claims against Lehman.

For this reason, as well as the

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increasing risk in continuing to support Lehman as that week

progressed, we requested an additional $5 billion in cash

collateral.

believed could be justified as a risk management matter, but

it was an amount that we also believed, based on their own

statements, that Lehman could handle.

This amount was still less than what we

Not withstanding our efforts to provide support

to Lehman in the marketplace, a run on the bank eventually

ensued for reasons wholly unrelated to JPMorgan.

However,

JPMorgan never turned our back on our client.

to make enormous discretionary extensions of credit to

Lehman, and to trade with the bank directly and for the

benefit of prime brokerage clients, as well as to accept

novations.

We continued

Even after Lehman filed for bankruptcy, JPMorgan

continued to extend many tens of billions of dollars of

credit to Lehman on a daily basis, allowing the broker

dealer to stay afloat long enough to sell its business to

Barclays Capital and transfer more than 100,000 customer

accounts.

As a result of our continuing support to Lehman,

JPMorgan ended up with nearly $30 billion in claims against

the bankruptcy estate.

claims arose out of exposure that JPMorgan took on after the

Lehman bankruptcy filing, as part of our efforts to support

More than $25 billion of those

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Lehman in these increasingly distressed markets.

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I appreciate this opportunity to share my views,
and I look forward to your questions.

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CHAIRMAN ANGELIDES:
Zubrow.

Mr. Miller.

WITNESS MILLER:

CHAIRMAN ANGELIDES:

WITNESS MILLER:

Thank you very much, Mr.

Thank you, Mr. Chairman.
Microphone, please.

Thank you, Mr. Chairman.

appreciate the opportunity to testify before this

Commission.

a partner in the Law Firm of Weil, Gotshal & Manges, which

is the major law firm involved in the bankruptcy case of

Lehman Brothers.

My name is Harvey Miller.

I am an attorney and

My role is to present the circumstances

surrounding the commencement of a bankruptcy case by Lehman

Brothers Holding, Inc., on September 15, 2008.

virtually impossible to summarize in five minutes my written

testimony, but I will try to do the best I can.

It would be

The commencement of the formal bankruptcy case

was totally unplanned.

contemplation of Lehman as it struggled through the

economy's financial slowdown during 2008, and was subjected

to the negative effects of the collapse of Bear Stearns and

Co., in March of that year.

Bankruptcy was never in the

At the time of the bankruptcy filing, the Lehman

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enterprise represented the fourth largest investment banking

firm in the United States.

reported assets of over $6 billion and liabilities close to

that amount.

The consolidated enterprise had

The Lehman enterprise was global.

It operated

pursuant to a classic holding company structure.

Brothers Holdings was the parent corporation.

and directed the affairs of the subsidiaries and affiliates.

Lehman

It managed

While Lehman had over 8,000 subsidiaries,

approximately 100-plus were active and engaged in the

business.

center in the world.

derivatives, commercial loans, underwriting, real estate,

bank ownership, and broker dealer operations.

Lehman had offices in every major financial
Lehman's business included

At the time of the filing, the enterprise

employed approximately 26,000 people, persons.

employees were located in New York City.

enterprise engaged in thousands of transactions involving

the movement of billions of dollars.

Over 10,000

Each day the

The parent corporation acted as a bank for the

Lehman enterprise.

operations was swept into cash concentration accounts at the

holding company, and each morning cash would be disbursed to

various subsidiaries and affiliates as needed.

Generally each night all cash from

Lehman's cash needs were supported by substantial

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borrowings.

term, which negatively affected Lehman's ability to

refinance as the economy slowed and was adversely impacted

by the expanding subprime mortgage crisis that began in

2007.

A large portion of those borrowings were short-

Lehman's liability depended to a large extent on

the confidence of the financial markets and the public.

disclosure of bankruptcy consideration would have been

disastrous to its continued operations.

Any

Public comments made after the collapse of Bear

Stearns by various hedge fund spokesmen and others as to

Lehman's alleged insolvency and vulnerability to bankruptcy

had a negative effect on Lehman.

During the week preceding September 15, 2008,

Lehman's financial condition materially deteriorated and was

aggravated by the announcement of negative quarterly

earnings.

became more precarious.

demands of its clearing banks for additional collateral

security and guarantees or face loss of clearing facilities.

As that week progressed, Lehman's situation
Lehman was being bombarded by

Lehman was confronting a major liquidity crisis.

Substantial pressure had been applied and was intensified to

find a major partner--a merger partner or a sale to resolve

its financial distress.

During that time, negotiations were ongoing as to

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a possible merger or sale involving Bank of America or,

alternatively, Barclays.

reorganization attorney occurred during the week of

September 8, 2008, when my firm was first contacted as to

potential bankruptcy planning if an alternative transaction

or other financial support was not forthcoming.

My involvement as a bankruptcy and

At that time, almost all senior Lehman personnel

were involved in the merger or sale discussions and, as a

consequence, there was no direct contact with Lehman

personnel.

The direct personnel contact began during the

evening of Friday, September 12th, when there was a meeting

at Lehman with representatives of the Federal Reserve Bank

of New York to get a determination as to the liquidity of

Lehman.

That meeting, which was attended by a large

portion of the financial staff of Lehman, included the CFO,

and it was reported at that meeting that Lehman would not be

able to give a complete picture on its liquidity until the

close of all the markets and all the information came in

from its global offices so that the conclusion would not be

available until late that evening or that night, or Saturday

morning.

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The events that followed after that were very
dramatic, including meetings over the weekend at the Federal

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Reserve Bank of New York.

The net of those meeting was a

decision that was made, and Lehman was told that there would

be no federal assistance, and essentially suggested or

directed that the Lehman representatives return to the

Lehman headquarters, cause a meeting of the board of

directors to be convened, and that Lehman should adopt a

resolution to commence a bankruptcy case before midnight of

that day.

That was an impossible task, but after

consideration of the inevitability of bankruptcy because of

the lack of liquidity, a bankruptcy petition was filed at

2:00 a.m., electronically, with the United States Bankruptcy

Court for the Southern District of New York.

There were many events and many facts that went

into what occurred, and the systemic consequences that

resulted during the following week.

have the opportunity to answer questions that the Commission

may have, and I refer to my written testimony as to the

circumstances which surrounded the filing of the bankruptcy

petition and my conclusions or opinions as to why that

decision was made by the regulators.

Thank you, Mr. Chairman.

CHAIRMAN ANGELIDES:

I am very pleased to

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Thank you, Mr. Miller.

Mr.

Fuld.
WITNESS FULD:

Chairman Angelides, Vice Chairman

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Thomas, and Members of the Commission, thank you for the

invitation to appear before you today.

Lehman's demise was caused by uncontrollable

market forces and the incorrect perception and accompanied

rumors that Lehman Brothers did not have the capital to

support its investments.

of confidence which then undermined the firm's strength and

soundness.

All of this resulted in the loss

Those same forces threatened the stability of

other banks, not just Lehman, but Lehman was the only firm

that was mandated by government regulators to file for

bankruptcy.

protect those other firms and the entire financial system.

The government then was forced to intervene to

In March 2008, Bear Stearns nearly failed.

believed then and still do now that had the Fed opened the

window, the financing window, to investment banks just

before the Bear problem, that decision might have provided

the necessary liquidity to keep Bear Stearns operational

and, more importantly, might have lessened the need for

additional government intervention.

With Bear Stearns gone, Lehman as the next

smallest investment bank became the focus of the marketplace

and was subject to increasingly negative and inaccurate

market rumors.

Critically, in 2008 Lehman reduced its total

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exposure to less liquid assets by almost 50 percent, going

from approximately $126 billion to $69 billion.

strengthened our capital and liquidity positions by raising

$10 billion of new equity, and pursued a wide variety of new

capital opportunities.

We further

During that same period, Lehman proposed to

government regulators converting to a bank holding company

and imposing a ban on naked shortselling.

requests were denied for Lehman, but granted for other

investment banks shortly following Lehman's bankruptcy

filing.

Both of those

Unfounded rumors about Lehman continued to

besiege the firm and erode confidence.

very existence depends on confidence to consummate

transactions, to pledge collateral, and to repay loans.

Without that confidence, no bank can function or continue to

exist.

An investment bank's

This loss of confidence in Lehman, although

unjustified and irrational, became a self-fulfilling

prophesy and culminated in a classic run on the bank

starting on September 10th, 2008, leading to that Sunday

night when Lehman was mandated by government regulators to

file for bankruptcy.

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Notably, on that same Sunday the Fed expanded for
investment banks the types of collateral that would qualify

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for borrowings from its primary dealer credit facility.

Only Lehman was denied that expanded access.

I submit that, had Lehman been granted that same

access as its competitors, even as late as that Sunday

evening, Lehman would have had time for at least an orderly

wind-down or an acquisition, either of which would have

alleviated the crisis that followed.

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9

There are a number of completely incorrect claims
which have been held up as explanations for the demise of

Lehman Brothers.

persist in the public domain.

assertions are repeatedly made, that does not make them

true.

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15

To this day, these incorrect claims still
Just because those incorrect

I highlight some of these claims only because I
believe this committee needs to hear what is true.

First, there was no capital hold at Lehman

Brothers.

$28.4 billion of equity capital.

market rumors about Lehman's mark-to-market determinations,

even the Lehman Bankruptcy Examiner found immaterial

differences in the firm's asset valuations, ranging from a

low of $500 million to a high of $1.7 billion.

At the end of Lehman's third quarter, we had
In contrast to the false

Assuming that full $1.7 billion in additional

writedowns as estimated by the Examiner, Lehman still would

have had $26.7 billion in equity capital.

Positive equity

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of $26.7 billion is very different from the negative $30- or

negative $60 billion holds claimed by some.

Second, Lehman had adequate financeable

collateral.

September 12th, the Friday night preceding Lehman's

bankruptcy filing, Lehman financed itself and did not need

access to the Fed's discount window.

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9

Many people to this day do not know that on

In addition, on that Monday, September 15th,
Lehman's broker dealer subsidiary borrowed about $50 billion

from the New York Fed by pledging acceptable collateral.

The Fed was paid back 100 cents on the dollar.

What Lehman needed on that Sunday night was a

liquidity bridge.

Lehman was forced into bankruptcy not because it neglected

to act responsibly or seek solutions to the crisis, but

because of a decision based on flawed information not to

provide Lehman with the support given to each of its

competitors.

We had the capital.

In the end, however,

In retrospect, there is no question we made some

poorly timed business decisions and investments, but we

addressed those mistakes and got ourselves back to a strong

equity position with a tier one capital ratio of 11 percent.

We also had financeable collateral, and we also

had solidly performing businesses.

nothing about this profile that would indicate a bankrupt

There is nothing,

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company.

Let me just end by saying that I am proud to have

spent my entire business career of over 40 years at Lehman

Brothers, and I am more proud to have been its Chairman and

CEO for its last 14 years.

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7

I thank the Commission for its time and I look
forward to addressing any questions.

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10
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CHAIRMAN ANGELIDES:

Thank you, Mr. Fuld.

Mr.

Baxter.
WITNESS BAXTER:

Chairman Angelides, Vice

Chairman Thomas, Members of the Commission:
Thank you for the opportunity to speak about the

events that brought Lehman Brothers to bankruptcy, events

that occurred during 2008 when our Nation was in the midst

of the worst financial crisis it has experienced since the

Great Depression.

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I would like to start with a question that I'm
often asked about Lehman.

Why did you allow Lehman to fail?

It's an understandable question, but it contains

a false premise.

Brothers to fail.

Treasury Department, the SEC, and others tried incredibly

hard to save it to avoid the harmful systemic consequences

that we have seen.

The Federal Reserve did not "allow" Lehman
Instead, the Federal Reserve, the

In my written testimony I discuss in greater

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detail the Federal Reserve's actions to address the Lehman

problem.

matters.

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5

Now, given time limitations, I will focus on two

First, we needed a suitable merger partner for
Lehman.

Second, we needed that merger partner to provide

a guarantee similar to the one that JPMorgan Chase provided

in its acquisition of Bear Stearns wherein the acquiring

institution agreed to backstop Lehman's trading obligations

between the signing of the merger agreement and the merger

closing.

By Sunday, September 14th, at the government's

request a group of Lehman creditors and counterparties had

agreed to finance approximately $30 billion of Lehman's

illiquid assets to facilitate a Lehman rescue.

An indispensable element of the plan, however, as

Secretary Geithner and others have pointed out, was a

willing and capable merger partner.

there were two candidates:

As of that Friday,

Bank of America and Barclays.

On Saturday, September 13th, Bank of America

reached an agreement to acquire Merrill Lynch, thus leaving

Barclays as the only potential acquirer with the resources

and ability to merge with Lehman.

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On Sunday, September 14th, with the consortium
financing committed, we learned for the first time that

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Barclays could not deliver the needed guarantee without a

shareholder vote, which could have taken months, and there

was no way to predict if the shareholders would even vote

for the transaction to proceed.

Lehman simply didn't have the luxury of that

amount of time.

Government or the Financial Services Authority might waive

this requirement so the guarantee could go forward and the

rescue could proceed.

I explored with counsel whether the UK

I learned at the UK Government was not amenable

to a waiver.

that we needed to rescue Lehman, and we had no other

suitors.

Thus, Barclays ceased to be the capable buyer

This guarantee was indispensable to Lehman's

rescue.

instructive.

acquiring party, JPMorgan Chase, that guaranteed Bear's

trading obligations from the merger announcement in March of

2008 to the merger closing in June of 2008.

Our experience with Bear Stearns is most
With Bear we had a willing and capable

This kept Bear as a going concern and provided

the necessary protection to counterparties during one of the

most vulnerable periods in any transaction, the period

between merger contract and merger closing.

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25

If during that critical period a merger falls
apart because of a failed shareholder vote, for example, the

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counterparties will not be protected against the obvious

risk of the target's bankruptcy.

Federal Reserve did not intervene and guarantee the trading

obligations of Lehman pending its merger with Barclays.

Many have asked why the

They observe that we lent approximately $29

billion to facilitate the merger of JPMorgan Chase and Bear

Stearns, and they look at our commitment to lend up to $85

billion to AIG.

Under the law, the New York Fed does not have the

legal authority to provide what I would characterize as a

'naked guarantee,' one that would be unsecured and not

limited in amount.

pledge the amount of collateral required to satisfactorily

secure such a Fed guarantee.

Lehman had absolutely no ability to

Finally, without security a guarantee of this

kind would present enormous risk to the American taxpayer.

Upon a Lehman default, the taxpayer would be liable for

Lehman's trading obligations.

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20

In the end, no rescue was affected because we had
no willing and capable merger partner.

Thank you again for the opportunity to speak to

you today, and I look forward to answering your questions.

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CHAIRMAN ANGELIDES:
Baxter.

Thank you very much, Mr.

We will now start with the questioning.
Mr. Fuld, I am going to start with you.

In your

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written testimony you indicated that Lehman's demise was the

result of turbulent market conditions.

stipulate at the start, given the growth in your

institution, the extraordinary leverage, the nature of the

assets, that also the risks taken by the institution also

led to its demise?

WITNESS FULD:

But would you

Let me try to talk to that.

You're asking me specifically how did we grow, and what was

the basis upon which we grew and thereby increasing risk?

CHAIRMAN ANGELIDES:

And I'm talking about your

leverage ratios, which of course exceeded 30 to 1 by 2007,

39 to 1 plus intangible equity, tangible assets to tangible

equity; the risk profile of the institution plus the

enormous growth.

billion I think, or $224 billion in 2000 to about $691

billion in 2007.

risk posture.

I mean asset growth from about $200

Just the risk profile, your aggressive

WITNESS FULD:

I would--I would say that the

aggressive risk posture is not an accurate depiction of how

we ran Lehman Brothers.

Our balance sheet certainly did grow.

we gained and increased earnings, which then became net work

and equity capital.

leverage ratio.

Please remember that we were one of the largest government

It grew as

We did in fact, in 2007, run a higher

At least half of that was our match book.

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dealers maybe even in the world.

series of short-term contracts to finance our clients that

bought governments and other securities.

And that match book was a

Having said that, we did in fact have too much

commercial real estate, as I have spoken about before.

had about $129- to $130 billion of what I called "less

liquid assets," which included about $50 billion--maybe a

touch more--of commercial real estate.

to $30 billion.

We brought that down

We had $45 billion of leverage loans, which we

brought down to about $9 billion.

of residential mortgages, which we brought down to about $17

billion, and actually $4 of that $17 billion was sold to

BlackRock just prior to our filing, which never got

consummated.

We had about $35 billion

So all in all, we had about $130 billion.

brought that down to about $69 billion.

leverage down by increasing our capital, by taking $25

billion of writedowns, and by selling a lot of these less-

liquid assets.

We de-risked our positions.

We brought our

So that by the time

we got to the third quarter, we had a Tier One capital ratio

I believe was close to 11 percent, which by a number of

standards is fairly solid.

We had a strong liquidity pool, which

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unfortunately evaporated in three days after the run on the

bank ensued.

day, that our actions that included bringing down the

balance sheet, raising capital, pursuing solutions with the

regulators about asking for bank holding company status,

trying to pursue either capital providers or actual buyers

of the firm, that we pursued everything we possibly could

have to have prevented what occurred on that September 15th.

And we believe, and I believe clearly to this

CHAIRMAN ANGELIDES:

All right, let me ask you a

quick question, or a couple of quick questions, kind of

'yes/no' and your best recollection.

Were you ever told by federal officials that

there was no authority under 13.3 to lend to you, or to

provide liquidity pre-bankruptcy?

was the bar?

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WITNESS FULD:

Were you told that that

I never had that conversation, to

my recollection.
CHAIRMAN ANGELIDES:

All right.

Are you aware of

any collateral analysis that was done by the Federal

Government, by the Federal Reserve Board of New York, by

other federal entities in terms of the inadequacy of your

collateral?

assessment of your collateral, and insufficiency thereof?

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25

Were you ever in a sense presented with their

WITNESS FULD:

Not specifically our collateral,

but we did have three meetings with the Federal Reserve Bank

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of New York that reviewed our funding capabilities, whether

that involved collateral I assume that that was--

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4

CHAIRMAN ANGELIDES:

Are these the stress tests

you're talking about?

WITNESS FULD:

Well the stress tests were in fact

after our filing.

These were, these were funding reviews.

I actually participated in all three of them.

different other people that participated.

treasurer, our Chief Legal Officer, but we had three of

There were

Our CFO, our

those.

but it was June, July, maybe earlier.

feedback on those, and certainly no negative feedback.

I forget the dates offhand, to tell you the truth,

CHAIRMAN ANGELIDES:

Never did I get any

All right.

Earlier today we

entered into the record a chronology prepared by our staff

that had supporting documents, so let me just quickly make a

couple of notations I want to ask you and Mr. Baxter about.

First of all, if you look at this chronology,

which you lived so you don't have to review, gentlemen, but

it starts in March with the rescue of Bear Stearns, the

acquisition of Bear Stearns by JPMorgan, and concludes just

after the bankruptcy filing.

And here's what I take from it.

It's obviously

very hard, as the Vice Chairman said.

and trying to discern what happened in the moment.

obviously what the Federal Reserve has said is that

We're looking back
But

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assistance was not extended.

the policy decision.

why, of not assisting Lehman, or not assisting in a way

where there could be a more orderly wind-down.

I'm trying to get to what was

What was the strategic decision, the

And when I look at this chronology, at least my

first takeaway from this, is that it seems to me that over a

period of months what ends up being made is a conscious

policy decision not to rescue the entity.

my reading of the documents.

At least that's

It seems to me during the course of this time

that there was financial assistance considered with no legal

bar being offered up.

talking about a Maiden Lane type of facility.

For example in July Bill Dudley is

In July also there's discussions about the

willingness to provide funding under the PDCF if JPMorgan

does not unwind transactions.

along this chain where, for example, as late as September

10th Fed Assistant General Counsel Mark Vanderweed e-mails

Scott Alvarez, and he basically says that the working groups

have been directed to flesh out how a Fed-assisted B-of-A

acquisition transaction might look.

There are a number of points

According to the Bankruptcy Examiner, Mr.

Geithner told the Lehman Bankruptcy Examiner that he told

the FSA that government assistance was possible as late as

September 11th.

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There was a e-mail from Mr. Parkinson that refers

on September 11th to a Federal Board of New York financial

commitments.

table, albeit with substantial debate.

So it looks as though at least it is on the

It also looks like there's political

considerations at play.

Chief of Staff, says on the 9th of September that, quote,

he, quote, "can't stomach us bailing out Lehman.

horrible in the press."

Mr. Wilkinson, who is the Treasury

It will be

And there's another e-mail from Mr. Wilkinson

saying, on the 14th:

Doesn't seem like it's going to end

pretty.

writing the USG COM's plan for an orderly wind-down.

just did a call with WH, which I assume is White House, and

USG is united behind no money.

blink now.

No way government money is coming in.

I'm here
Also

No way in hell Paulson could

So I see consideration of financial assistance,

political considerations.

problems.

ask you.

political decision?

the surprise of Barclays not happening?

There's a recognition of systemic

But in the end, there's no rescue.

So I want to

Do you believe it was a conscious, strategic, and
Do you believe it was a result of just

What do you think was at the nub of the decision

not to rescue or provide liquidity for an orderly wind-down?

Mr. Fuld?

And then I'd like to ask you, Mr. Baxter.

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WITNESS FULD:

I thought you were

addressing that question to Mr. Baxter.

3
4

I apologize.

CHAIRMAN ANGELIDES:

Do you want me to repeat it

all--no.

WITNESS FULD:

lot.

through.

That was a lot, and you said a

I was not privy to that information that you just went

weekend.

I was not part of the conversations over the

For us it was less about--and I understand all

the noise about crisis and bailout and moral hazard.

had the capital.

that last week with over $40 billion of liquidity.

close to 30 of it in three days.

the bank.

We needed the liquidity.

Lehman

We went into
We lost

It was a classic run on

We needed the liquidity.

I really cannot answer

you, sir, as to why the Federal Reserve and the Treasury and

the SEC together chose not to not only provide support for

liquidity, but also not to have opened the window to Lehman

that Sunday night as it did to all of our competitors.

And I must tell you that when I first heard about

the fact that the window was open for expanded collateral, a

number of my finance and treasury team came into my office

and said we're fine.

it.

and said:

We're fine.

We have the collateral.

We can pledge

Forty-five minutes later, they came back

That window is not open to Lehman Brothers.

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CHAIRMAN ANGELIDES:

chronology.

Yes, that's in the

this.

All right, Mr. Baxter, let me follow up on

You see political considerations in this

timeline.

never see anyone say during the months, we can even consider

financial assistance because the condition of Lehman won't

allow it.

the assets didn't so precipitously drop in a matter of days

You see a debate about financial assistance.

And I'm assuming that the kind of valuation of

so as to change the collateral equation.

But I also see in this chronology that Mr. Hoyt

at Treasury actually says on July 11th, the Fed has plenty

of legal authority to provide liquidity.

not to, which I doubt we would, but he talks about the

authority, and then also there's assessments in here about

impact, about an acknowledgement that, for example, it would

be much more--this is a September 11th memo from Jason Mu to

Mr. Bernanke saying it would be a much more complex

proposition to unwind Lehman's positions than Bear Stearns

because Lehman has twice as many positions.

number of other studies in here that said, look, there's

going to be tremendous impact.

And if we choose

There's a

The size of the triparty repo book was much

larger than Bear's, about $182 billion versus $50 to $80

billion.

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Tell me all the policy considerations that go in?

Or was it that from day one you were saying legally not

possible?

lot of debate, a hell of a lot of debate here, about whether

or not to rescue, whether or not to provide for an orderly

transition, and none of this was cut off by a legal opinion

and said not possible.

8
9

Because it sure looks like there's a heck of a

And we saw in the Wachovia instance, of course,
that a legal opinion to facilitate a transaction, you know,

came about.

opposite where apparently you're saying there's now no legal

authority.

inability to act legally.

In this instance, you know, you see the

But at the time I see no evidence of the

WITNESS BAXTER:

Let me see if I can clarify what

exactly happened from the week beginning September 8th until

September 15th.

assistance was provided to Lehman, and I'll explain that in

a minute.

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20

And it is not true that no federal

CHAIRMAN ANGELIDES:

lending post-bankruptcy, the broker dealer--

WITNESS BAXTER:

CHAIRMAN ANGELIDES:

Yes, sir.
--which was substantial, but

post-bankruptcy.

WITNESS BAXTER:

CHAIRMAN ANGELIDES:

Are you talking about the

Yes, sir.
And the PDCF was available.

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WITNESS BAXTER:

And I'll explain that.

But I

think it's important to understand the framework that we

went into Lehman weekend with.

Plan A, if you will, was to facilitate a merger between a

strong merger partner and Lehman.

And our principal plan, our

That was Plan A.

And rest assured, Commissioners, we worked night

and day to try to make that plan happen.

politics.

It wasn't about

It was about getting to the right result.
Now as I explained in my full statement, and as I

explained in my oral statement this morning, we had a

problem with the facilitated merger-acquisition in that we

couldn't get the guarantee that we needed.

So the first question was:

All right, we have

financing, $30 billion of financing from the private sector,

reminiscent of what happened in 1998 with Long Term Capital

Management, and I was there, so we had that private sector

financing lined up.

It boiled down to the guarantee.

So the first question--and it's a legal question:

Could the Fed issue a naked guarantee, a guarantee unlimited

in amount like JPMorgan Chase's were in the Bear

transaction, and unsecured?

22
23
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25

And the answer to that question is:

As a matter

of law, that cannot be done by the Federal Reserve.
Now look at what happened in the Congress of the
United States in October of 2008 when Express Guarantee

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authority was conferred on the Treasury--and I'm talking

about Section 102 of the Emergency Economic Stabilization

Act.

There you will see express authority for a

guarantee of the kind that I'm talking about.

no such legal authority.

13.3 of the Federal Reserve Act there's a requirement that

we're secured to our satisfaction.

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10

The Fed has

And the reason is that in Section

A naked guarantee of unlimited amount, unsecured,
does not meet that statutory requirement.

So Plan A couldn't be executed.

Full stop.
Now Secretary

Geithner, when I worked for him when he was president of the

New York Federal Reserve Bank, used to say to the staff, and

sometimes in an animated way, "plan beats no plan."

So he was not going to allow us to be in a

position where we had no contingency plan.

contingency plan for the facilitated merger-acquisition of

Lehman, was the following:

So our

The parent would file a Chapter 11 Petition.

The

U.S. Broker Dealer would stay in operation with the benefit

of Federal Reserve liquidity until such time as a proceeding

could be commenced under the Securities Investor Protection

Act.

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25

That was the contingency plan.
you will.

The Plan B, if

Now just to give you a dimension--

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CHAIRMAN ANGELIDES:

WITNESS BAXTER:

Let me ask you a question--

Let me give you a dimension to

this.

CHAIRMAN ANGELIDES:

But let me just ask you a

question, because you said something--you've presumed this

would be unsecured.

So your position--

WITNESS BAXTER:

--guarantee, sir.

CHAIRMAN ANGELIDES:

WITNESS BAXTER:

Okay, but--all right, but--

I'm moving on now to describe

the secured facility.

Dealer, we had two widely available programs.

Primary Dealer Credit Facility that Mr. Fuld mentioned.

Another was the Term Securities Lending Facility that we

initiated on March 11th of 2008 before Bear.

third were routine Open Market operations.

And with respect to the Broker
One was the

And then the

So those facilities were fully available to

Lehman.

facilities available to Lehman's Broker Dealer post-

petition?

The question was:

Would we continue those

And we decided the answer would be yes.
Now on Monday, September 15th, in the evening--so

I'm talking about post-petition by the parent, we extended

credit to the U.S. Broker Dealer in the amount--and this is

approximate--of $60 billion across the Primary Dealer Credit

Facility, the Term Securities Lending Facility, and Open

Market Operations.

All of those are fully secured.

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CHAIRMAN ANGELIDES:

I'm aware of that.

But let

me just ask this brief question, because I want to move on

and let the other Commissioners ask.

Why was it not extended prior to?

WITNESS BAXTER:

The facilities were always

available to Lehman pre-petition, and they were available to

Lehman post-petition.

this.

Mr. Fuld is simply incorrect about

In the record of this Commission there's a letter

to Lehman by Chris Burke, a New York Fed officer, and it

says:

haircuts were steeper post-petition, but the facilities were

available, and they were used:

and approximately $45 billion on September 16th, and another

$45 billion on September 17th.

You have access to these facilities.

Now the

$60 billion the first night,

So there's a misunderstanding about what was

happening here.

after the petition was filed by the parent.

secured.

situation from the naked guarantee which was not secured and

not limited in amount, and not within the authority of the

Federal Reserve.

23
24
25

There was lending to the U.S. Broker Dealer
It was fully

And that distinguishes, that distinguishes this

CHAIRMAN ANGELIDES:

All right.

I'm going to

return for more questioning later, but thank you very much.
Let me go to the Vice Chair now.

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VICE CHAIRMAN THOMAS:

Thank you, Mr. Chairman.

For those of us who reside in the second half of the

alphabet, we appreciate your courtesy in terms of starting

with "Z" and working over to "B" on the panel.

not familiar with how rarely we get that kind of an offer.

You're just

I would ask each of you, if you would, to

verbally respond to our request that, as in the case with

every panel, we wind up with questions after the panel is

over; and that if we could submit written questions to you,

would you give us a timely, whatever that means, a written

response?

Would you be willing to do that?

(Nods in the affirmative.)

WITNESS FULD:

VICE CHAIRMAN THOMAS:

Yes.
Okay, thank you, because

it's hard to record head nods.

I am willing to admit that I have never, ever had

an interest in, never followed, although I had to and others

have, all the intricacies that we're trying to discuss.

I am going to ask some questions that are just kind of

questions that most anyone would ask.

We focused on Bear Stearns.

We understand there

was someone, JPMorgan, who was willing to take on that

relationship.

continued on for, what, five months, going onto six months

by the time that we had gotten to September.

Now this was in March, right, of '08.

Events

Could any of

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you give me some understanding of the mental set of folks

who had seen what happened to Bear, and you're looking--I

believe, Mr. Fuld, you talked about, you know, who's next in

line in terms of size, and ability.

looking around in beginning to assume if what happened to

them, God forbid, there but for the Grace of God went me,

but maybe now, or I, and now it may be me?

8
9

Didn't somebody start

Was there any concern or activity about this,
trying to look for potential connections?

Was there

discussion on the street, or behind closed doors?

Fed, were you guys talking about we may have to hook up a

few more marriages?

September period?

Or at the

What was going on in that March to

Anybody?

WITNESS FULD:

Let me try to help you with that.

At the time of Bear Stearns, the record book as I understand

it speaks to JPMorgan's first, second, and third cut at

acquiring Bear Stearns was negative.

come back, create, recreate, find capabilities that would

give JPMorgan the comfort with which to consummate this

transaction.

The Fed continued to

So when that transaction was finished, that set

two precedents.

capital providers to understand where the government was in

their position, to either be a part of it or not part of it,

to provide liquidity.

One, very difficult going forward for new

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The Fed did open the window after Bear Stearns,

which was a very positive move.

the question of liquidity.

investors around the world and counterparties, that did in

fact mean that the Fed was there to provide liquidity for

noncommercial bank entities, meaning investment banks.

In my view, that did answer

And to a number of other

It also set another precedent, though, in that

the terms used were "crisis," were "bailout," and as I said

in both written and oral testimony, had the Fed provided

liquidity prior to the Bear problem, I think those words of

"crisis" and "bailout" never would have been used.

I think it would have alleviated the problem.

can't talk about what was in Bear's book because I don't

really know, and it would be inappropriate for me to do so,

but I did see their stock drop from $80, to $60, to $40, to

$2, later at $10.

Chairman said I don't know how those assets changed so

quickly in a seven day period.

And as you correctly said earlier, the

So this was clearly a time of loss of confidence.

A ton of rumors were swirling.

down.

asset sales, will these firms have enough capital to support

those losses?

24
25

Stock prices were going

And investors were saying, if there continue to be

So that is the beginning.

During that entire

time, all the banks, not just Lehman, de-risked, raised

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1

capital, and I would tell you that for Lehman itself we

raised, and I mentioned it, $10 billion of new equity

capital.

close to let's say three, I think it was $3.7, $3.8 billion

more than we lost net.

If you look at our total net losses, we raised

So with all our capital raises and all of our net

losses, we came out close to $4 billion with additional

capital, $4 billion of additional capital than when we

started.

10
11

I don't want to take you through the whole litany
again--

VICE CHAIRMAN THOMAS:

No, that's okay, because

that gets me then to--and I want to make sure I understood

you correctly, Mr. Baxter, where you said that Lehman did

not have the collateral to back a sufficiently large bridge

loan.

Is that correct?
WITNESS BAXTER:

No, Vice Chairman.

I was

talking about the naked guarantee, a guaranty of the trading

obligations of Lehman between merger with Barclays and

closing of that merger.

And if you look back to the March transaction

between Bear Stearns and JPMorgan Chase, you will see a

guaranty without limit, and a guaranty that was unsecured.

So we were working off that model.

authority to issue that kind of guaranty.

And the Fed has no

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VICE CHAIRMAN THOMAS:

I understand that.

But

what I hear Lehman saying is that they needed some

assistance on--for liquidity; that they needed a liquidity

bridge, if not a collateral bridge.

is:

there others?

And my only question

Why was Barclays the only one who stepped up?

WITNESS BAXTER:

Were

Well first let me say, in the

period leading up to Lehman weekend--so that's the period

from Bear Stearns mid-March 2008 to September 2008--

10
11
12

VICE CHAIRMAN THOMAS:

April, May, June, July,

August-WITNESS BAXTER:

On the basis of what I read in

Mr. Velucas's report, Mr. Fuld was working very hard to try

to find a merger partner for Lehman.

that six-month period, I don't believe, succeeded.

And Mr. Fuld, during

So when we got to Lehman weekend, what the

government was trying to do is facilitate a merger of Lehman

by coming up with a private-sector group who would finance

illiquid assets and make Lehman more amenable to an

acquiring institution like a Merrill Lynch or a Barclays.

Now those were the two institutions that were

interested in a possible merger with Lehman at the time.

The important point--and it is really an important point to

focus on--is that we had the committed financing.

gotten to that point by Sunday, September 14th.

We had

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1

So $30 billion was going to be provided by these

private-sector institutions to take the illiquid assets out

of Lehman to facilitate that merger.

point.

get that deal done.

A really important

And yet, even with that, even with that, we couldn't

So the problem, as we got--

VICE CHAIRMAN THOMAS:

foreign bank?

9
10

WITNESS BAXTER:

VICE CHAIRMAN THOMAS:

WITNESS BAXTER:

You know what happened with Bank

of America is they decided to merge with Merrill Lynch.

VICE CHAIRMAN THOMAS:

WITNESS BAXTER:

Yes.

On Saturday, September 13th.

we couldn't get the merger done.

became:

Time lines couldn't

produce--

13
14

Barclays was a foreign bank and

wouldn't produce the guaranty.

11
12

Because Barclays was a

And then the question

Okay, what's the best alternative plan?
And in our view, and in the view of our

bankruptcy advisors, the best alternative plan was to put

the parent into a Chapter 11 proceeding and to keep the U.S.

broker dealer alive with bridge financing from the Fed--not

alive, waiting for some other hypothetical merger partner to

arrive, because we didn't think that would ever happen; but

alive along enough to conduct this orderly, orderly winddown

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1

of its positions until we could do the CIPRA proceeding.

That was the contingency plan.

VICE CHAIRMAN THOMAS:

Okay, my problem is, on

page 9 of your testimony--and this is where I need to have

you explain to my your testimony--you say in the first

paragraph, quote:

pledge the amount of collateral required to satisfactorily

secure a Fed guaranty, one large enough to credibly

withstand a run by Lehman's creditors and counterparties.

"In this case, Lehman had no ability to

WITNESS BAXTER:

Let's imagine a--

VICE CHAIRMAN THOMAS:

WITNESS BAXTER:

How short were they?

Let's imagine an unlimited

guaranty of the trading obligations of Lehman, which was

$600 billion in asset size.

collateral would you need for a guaranty of that kind?

So how much?

How much

And you can imagine that happening under the new

authority in the Emergency Economic Stabilization Act, and

how would you score it for purposes of the authorization,

which was $700 billion?

authorization?

Would it wipe out the entire

Perhaps it would.

And that's the point that I was trying to make,

perhaps inelegantly on page 7, is this is a guaranty of

enormous size.

it, you'd need hundreds of billions of dollars of

collateral, and Lehman didn't have that.

If you wanted to collateralize it to secure

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VICE CHAIRMAN THOMAS:

They didn't have it, and

they went into bankruptcy.

an indication that Lehman was maybe too big to fail based on

what happened after Lehman?

could go right to some definition--we've always had

difficulty in defining "too big to fail"--that you went

fairly close to the border, and that Lehman wasn't too big

to fail?

expected?

In hindsight, was that tipping

Or was it evidence that you

And that the consequences of Lehman failing were

I'm trying to understand what would have happened

post-Lehman, had there been a bridge sufficient--although I

don't understand where it's a bridge to, because if there

wasn't anyone that would acquire them.

WITNESS BAXTER:

We thought it was a bridge to

nowhere in that particular point in time.

to the overall point that you were making, Vice Chairman, I

do believe Lehman was systemic.

was the only systemic trigger, particularly during this

incredible month of September 2008 which began with the

conservatorships of Fannie Mae and Freddie Mac.

not our only problem during that month, as you know.

But with respect

I don't believe that Lehman

Lehman was

The day after Lehman filed its petition, we had

AIG.

an extraordinary point in the crisis, and I think one of the

most historic months in the history of American finance.

And at the end of the month we had WaMu.

So this was

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1

So had Lehman failed in May, it might have been a

different circumstance, prior to this extremely confusing

month of September?

WITNESS BAXTER:

I believe Lehman would have been

systemic in May.

it was systemic in September.

It would have been systemic in March.

VICE CHAIRMAN THOMAS:

Okay.

And

Mr. Chairman, I

want to reserve my time because I know there are others who

have a whole series of questions they want to ask, and I

took more than my usual time in the first panel, so I will

reserve my time.

CHAIRMAN ANGELIDES:

Mr. Holtz-Eakin?

COMMISSIONER HOLTZ-EAKIN:

Thank you,

Mr. Chairman.

17
18

I'm going to mix it up a

little.

15
16

Thank you.

CHAIRMAN ANGELIDES:

Being a strategic advantage

on you.

COMMISSIONER HOLTZ-EAKIN:

Thank you, gentlemen,

for taking the time to be with us today and to help us with

this.

I want to go back to this issue of the

availability of the PDCF to Lehman on Sunday night.

And I

simply cannot reconcile the two things I've heard.

And so

my question to you, Mr. Baxter, is:

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1

Did everyone have the same access to that

facility, using exactly the same collateral, right up to the

point when Lehman filed at 2:00 a.m.?

WITNESS BAXTER:

primary dealers to borrow?

"Everyone" means the eligible

COMMISSIONER HOLTZ-EAKIN:

WITNESS BAXTER:

COMMISSIONER HOLTZ-EAKIN:

Yes.

There was-Including Lehman,

importantly.

COMMISSIONER HOLTZ-EAKIN:

There was--and it's a

complicated question, and I want to make sure I answer it

completely.

First of all, there was new authority under

Section 13.3 to expand the collateral available for the

PDCF.

16
17

COMMISSIONER HOLTZ-EAKIN:
in Resolutions that afternoon--

18
19

Which had been passed

WITNESS BAXTER:

Correct, by the Board of

Governors.

COMMISSIONER HOLTZ-EAKIN:

WITNESS BAXTER:

Thank you.

And those modified the earlier

13.3 resolutions that came over a Bear Stearns weekend, and

that enabled us to set the PDCF up for operation on March

17th, 2008.

So those are two things.

With that understood--

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1

COMMISSIONER HOLTZ-EAKIN:

WITNESS BAXTER:

Right.

--and there may have been

miscommunication in the fog of that particular Sunday

between the Fed and Lehman Brothers.

But with that understood, what was decided is

that Lehman had access to the PDCF with the expanded

collateral, but with a higher haircut.

COMMISSIONER HOLTZ-EAKIN:

WITNESS BAXTER:

COMMISSIONER HOLTZ-EAKIN:
to filing at 2:00 a.m.

13
14

prior

I'm sorry, I didn't understand

you.
Prior to filing, exact same terms for Lehman as
for all other primary dealers.

17
18

My question was

That's the question.

WITNESS BAXTER:

15
16

A higher haircut--post-

petition--no.

11
12

Prior to filing?

COMMISSIONER HOLTZ-EAKIN:
understanding?

Mr. Fuld, is that your

And if not, why?

WITNESS FULD:

That is not my understanding at

all.

My understanding was that the Fed opened the window to

investment banks with an expanded definition of acceptable

collateral.

COMMISSIONER HOLTZ-EAKIN:

WITNESS FULD:

came in to see me--

Um-hmm.

Not to be repetitive, my people

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1

COMMISSIONER HOLTZ-EAKIN:

WITNESS FULD:

When?

I forget what time, but it was in

the later part of Sunday, in the afternoon, and said:

fine.

we are fine.

We're

The Fed just opened the window, expanded collateral,

Forty-five minutes later, they came back.

What

we were told--I'll put it this way.

that the Fed said:

capability for expanded collateral--we're opening the window

What I was told was

Yes, we are expanding the window

for expanded collateral, but not for you, Lehman Brothers.

That's what was told to me.

COMMISSIONER HOLTZ-EAKIN:

As is usual, when

confusion reigns, let's go to the lawyers.

is your understanding of this sequence of events?

15
16
17

WITNESS MILLER:

Yes, sir.

Mr. Miller, what

I have a different

perspective on it.
You have to understand that we were talking about

Lehman Brothers Holdings, Inc., the parent company, which

ran the whole enterprise.

The PDCF window, which was discussed during the

late afternoon, Sunday afternoon, at the Federal Reserve

Bank, from my impression the condition on that window being

open was that Lehman Brothers Holdings, Inc., would file a

bankruptcy petition.

And if Lehman Brothers Holdings, Inc., filed a

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1

bankruptcy petition, the Fed would make available to Lehman

Brothers, Inc., the broker dealer, an overnight repo and the

other financing that Mr. Baxter referred to.

Those funds would only be available to fund the

broker dealer, and not the other operations of Lehman, which

were very extensive.

financing, but it was limited to one entity.

condition was that there would be--it wasn't even called a

Chapter 11 filing, a bankruptcy petitioned filed before

So that it was a very--it was a PDCF
And the

midnight.

COMMISSIONER HOLTZ-EAKIN:

WITNESS MILLER:

COMMISSIONER HOLTZ-EAKIN:

WITNESS MILLER:

Okay.

Now if I could just add, sir-Please.

--going back to the Chairman's

questions, during that fateful Sunday afternoon, and going

into the early evening, the list of 'yes' or 'no' questions

that the Chairman posed, at no time during the meeting down

at the Fed were the Lehman representatives and the team from

my office advised as to any of the rationale for what was

being directed.

There came a point in that meeting in which

basically we were told:

of directors together, and pass a resolution to file a

bankruptcy petition.

Brothers, Inc., as a broker dealer was not qualified to file

Go back to Lehman.

Get the board

And then we will allow, because Lehman

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1

under Chapter 11 as a stock broker, we will allow LBI,

Lehman Brothers, Inc., to continue to operate for a week or

so so that customer accounts could be dealt with.

ultimately at some point in time there would be a proceeding

under the Securities Investor Protection Act.

6
7

It was just a temporary financing to get from A
to B.

8
9

And, that

COMMISSIONER HOLTZ-EAKIN:
prove I'm truly confused.

So I'm now going to

So what I think you just told me

is that the broker dealer, which I believe should have had

access on the same terms as everyone else, to the PDCF, was

told it didn't have access unless there was a filing by the

parent?

14
15

WITNESS MILLER:
yes, sir.

16
17

In the context of that meeting,

COMMISSIONER HOLTZ-EAKIN:

That's what you

understood them to say?

WITNESS MILLER:

Yes, sir.

COMMISSIONER HOLTZ-EAKIN:

Mr. Baxter, is that

right?

Sunday night on the same terms as everyone else?

Or could the broker dealer have accessed it on

WITNESS BAXTER:

It's not right.

And that's why

we put it in writing.

is an officer of the New York Fed to Lehman Brothers.

in the--you have it in the record, and you can look at that

There's a letter from Chris Burke who
It's

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1

and see what we said in plain terms.

There shouldn't be doubt about this.

You have it

in writing.

concerned that communications weren't as robust as they

should be.

And we put it in writing because we were

And if you were--if I could take you back in time

to Sunday, September 14th, and you could be with us, having

been up for several days, not only the people at the Fed but

the people at Lehman Brothers, you might understand better

why there could have been a lack of clarity in terms of the

communications.

Now there was also discussing about a lending--

COMMISSIONER HOLTZ-EAKIN:

the lending--Point of clarification.

I just want to know the timing of the letter.

letter sent afterwards?

VICE CHAIRMAN THOMAS:

Could I ask you about
When was the letter?
Was the

We would like to ask the

questions based upon our reaction to what you say.

continue talking, we can't do that.

understand.

it, not withstanding the continuity problems, that you would

let them make the point.

23
24
25

If you

We're trying to

When we ask you to suspend, we would appreciate

CHAIRMAN ANGELIDES:

And that was on somebody's

time, not yours.
COMMISSIONER HOLTZ-EAKIN:

I'll take it.

It's

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1

okay.

So an observation, which is that I understand how

tired and difficult it was to understand, because I was on

the McCain Campaign at the time and you ruined my life--

(Laughter.)

COMMISSIONER HOLTZ-EAKIN:

was the letter sent to clarify?

And number two, when

when was the letter sent?

8
9

WITNESS BAXTER:
one letter among many.

Was this because after--

You know, I'm trying to remember

I think it was September 15th.

COMMISSIONER HOLTZ-EAKIN:

WITNESS BAXTER:

Okay.

But--but we'll provide another

copy, and the letter will speak for itself.

COMMISSIONER HOLTZ-EAKIN:

So that night, it very

well could have been the case that in the confusion Lehman

was told they had no access, which they really did have?

16
17

I mean, I'm just trying to reconcile what's going
on here.

WITNESS BAXTER:

confusion about that particular point.

20
21
22

I don't think there was

COMMISSIONER HOLTZ-EAKIN:

Then why send the

letter?
WITNESS BAXTER:

I also don't think there was

confusion about the decision by the Lehman Board of

Directors, the parent, to file bankruptcy.

discussion with the board late on Sunday evening, and I

Because we had a

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1

participated in that discussion along with Chairman Cox, and

I believe the Board of Directors of Lehman fully understood

that they had to make a decision with respect to that

filing.

I believe they made that decision in consultation

with counsel.

probably show that the directors fully understood that they

needed to make the fiduciary decision about whether or not

to file, and that there was no strong-arming or leveraging

10
11

I believe the minutes of that meeting should

with respect to facilities of the Federal Reserve.
That was their decision to make, and they had

very competent counsel advising them at the time.

have no question--

COMMISSIONER HOLTZ-EAKIN:

WITNESS BAXTER:

COMMISSIONER HOLTZ-EAKIN:

17
18

And I

We're clear on that--

--no question that-I'll yield to the

Chairman for a second.
CHAIRMAN ANGELIDES:

Let me ask a quick question.

So just to put a punctuation mark on it, apparently there

was confusion because Mr. Fuld seemed to have a different

understanding, and Mr. Miller seemed to have a different

understanding.

And then apparently in our staff interviews of

Mr. McDade and Mr. Lowett, what the chronology we put out

today indicates is, it says Baxter tells them that Lehman

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1

cannot access the expanded window and had to file

bankruptcy.

3
4

So you dispute that?

You said you never told

that to nobody?

WITNESS BAXTER:

CHAIRMAN ANGELIDES:

infer all this?

Correct.
So how did all these people

mean, how does that happen?

9
10
11

Why did they come to this conclusion?

WITNESS BAXTER:

I think you'll have to ask them

that, Mr. Chairman.
CHAIRMAN ANGELIDES:

I guess I'll ask all of you,

but I guess we have asked all of you.

WITNESS BAXTER:

CHAIRMAN ANGELIDES:

I would look at the letter.
Well the letter, what I

understand now from the letter--and this is on my time--is

it came the 15th, you're saying, the day of the filing.

the Sunday, which was the 14th.

Not

All right, Mr. Holtz-Eakin, thank you very much.

COMMISSIONER HOLTZ-EAKIN:

So why do you, Mr.

Baxter--how can you then explain why Mr. Fuld, who says he

just needed a liquidity bridge, did not take the one that

you're telling me he had?

23
24
25

WITNESS BAXTER:

I'm trying to understand that

question which asks about Mr. Fuld's state of mind.
COMMISSIONER HOLTZ-EAKIN:

If there was no

185
1

confusion, that they had the same access as everyone else on

Sunday night, that they were never told they had to file

bankruptcy, they simply chose to, his testimony is all they

needed was access to something like the PDCF with expanded

collateral and they would have been able to continue

operation and continue to seek a merger partner.

they do that?

8
9

WITNESS BAXTER:

Why didn't

The U.S. Broker Dealer needed

access to funding the night of September 15th because the

triparty investors were no longer there.

could get funding was from the Fed.

required--

13
14

COMMISSIONER HOLTZ-EAKIN:

The only place it

So that funding was

That's the 15th.

That's afterwards.

WITNESS BAXTER:

The night of the 15th that

funding was needed, and we had to take over from our

brothers at JPMorgan Chase who were lending intraday.

that funding is committed.

So what you're talking about with additional

funding to rescue the Lehman parent is it comes on top of

the $60 billion that was already committed to the Broker

Dealer.

So, you know, if you take--if you take what, what

was offered in one of the statements that there was another

$40 billion needed, we're up to $100 billion now.

Now

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1

where's the collateral coming?

Those things are all, are all completely obscure.

3
4

How are you doing that?

COMMISSIONER HOLTZ-EAKIN:

WITNESS BAXTER:

COMMISSIONER HOLTZ-EAKIN:

WITNESS BAXTER:

9
10

That's all

I wanted--

Thank you.

So the difference is, funding-Thank you--

--the sub, or funding the

parent.
COMMISSIONER HOLTZ-EAKIN:

Thank you.

Mr. Fuld, could you have--he's saying you did not

have the combinatino of capital and collateral to make this

deal go, and thus had to, as a matter of your fiduciary

interest, do the filing.

WITNESS FULD:

Is that correct?
I'd like to clear up one piece.

If the letter was in fact sent on the 15th--

COMMISSIONER HOLTZ-EAKIN:

WITNESS FULD:

COMMISSIONER HOLTZ-EAKIN:

WITNESS FULD:

20
21

I know.

--we had already filed by then.
I know.

So thank you for the letter, but--

enough said on that.
We had $143 billion of combination of equity and

long-term debt.

$140, let's round it off, of what we called "unencumbered

collateral."

with our long-term debt and equity.

So be definition we had $143, maybe it was

That means collateral that we were financing
That's number one.

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1

We had the collateral.

Clearly, again, you don't need to hear it from

me, we had the capital.

whole businesses.

a business.

As with the case with AIG, we had

We could have put up Neuberger Berman as

We were in conversations with at least two, but

it was probably four that were thinking about buying

Neuberger Berman between $7 and $9 billion.

That had value.

We had $30-some-odd billion of private equity

funds.

that, as in fact a business, and used that as collateral.

So we had collateral both in securities and in

We could have carved off eityher all or part of

whole business forms.

COMMISSIONER HOLTZ-EAKIN:

Thank you.

I want to

try to get back down to one of the major themes of this

hearing, which is when institutions are perceived to be too

big to fail, and when it is appropriate for government to

step in.

I want to ask you, Mr. Zubrow, as a key

counterparty of Lehman, whether you concur with Mr. Fuld's

assessment of their financial condition on the 14th.

would you have provided repo on the 15th if they had

accessed the expanded PDCF?

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25

WITNESS ZUBROW:

And

I think it was clear in the

marketplace, both the week leading up to the weekend of the

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1

13th, as well as over that weekend, that there was, you

know, great concern in the marketplace among all sorts of

counterparties about the ability of Lehman Brothers to

continue to finance their various operations.

And so, going into that weekend, the triparty

book of financing was obviously held by investors, and the

question would then come up on Monday morning, the 15th, as

to whether or not we would be able to do an unwind and

provide intraday financing.

And certainly over the weekend of the 13th and

14th, we were very concerned that there would not be

sufficient investor counterparties to continue to finance on

the night of the 15th without a strategic resolution of the

entire Lehman situation.

COMMISSIONER HOLTZ-EAKIN:

So without a merger

partner, with only a bridge to the 15th, you do not think

there would have been a successful ability to sustain the

repo operation?

WITNESS ZUBROW:

It certainly appeared to us at

that point that there was not going to be investor appetite

to continue to finance Lehman's operations.

COMMISSIONER HOLTZ-EAKIN:

Okay.

In your view,

JPMorgan's view, was Lehman a systemically important

institution always?

found in September?

Or only in the market conditions you

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WITNESS ZUBROW:

I think there's no question that

Lehman was a very important counterparty to many people in

the marketplace.

systemic institution.

And as such they were a very important

I think the issue was obviously how was the

government going to try to resolve the situation.

Mr. Baxter said, there did not appear to be sufficient legal

authority and mechanisms for the various regulators to be

able to resolve the situation in the ways that obviously

And as

Congress has now provided for.

COMMISSIONER HOLTZ-EAKIN:

Mr. Baxter, when the

Federal Reserve was examining its options, what did it think

would happen in the marketplace if it had to go to Plan B?

What did it expect the fallout to be?

WITNESS BAXTER:

correct a mistake I made.

September 15th.

14th.

First, Commissioner, I want to
I said Chris Burke's letter was

it was pre-petition.

My counsel advises me it was September

So I was a day off, and it was quite material because

COMMISSIONER HOLTZ-EAKIN:

WITNESS BAXTER:

Okay.

All right, with that, again,

looking at the issues, we knew that there were going to be

terrible consequences with Plan B.

COMMISSIONER HOLTZ-EAKIN:

WITNESS BAXTER:

Specifically?

We knew that there was going to

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1

be disruption in the derivatives market.

going to be disruption with respect to triparty.

why we tried to step in with a backstop to what would

ordinarily be the money fund investors pouring money in

overnight.

We knew there was

So we anticipated those things.

And that's

And that's why

it was Plan B.

view, and that's why we worked so hard to try to get a

merger partner--

10
11

Plan A was way better from our point of

VICE CHAIRMAN THOMAS:

Mr. Chairman,

Mr. Chairman, I yield the gentleman five additional minutes.

COMMISSIONER HOLTZ-EAKIN:

To go back, you

mentioned you provided a backstop for money in the triparty-

-say that again?

WITNESS BAXTER:

Yes.

With respect to the--what

we were doing when we started the week, Monday, September

15th, is Chase was lending intraday.

COMMISSIONER HOLTZ-EAKIN:

19
20
21
22

Okay, so this is post-

filing.
WITNESS BAXTER:

Post-filing.

And then the Fed

was coming in and essentially taking the credit overnight.
Now we knew the consequences were going to be

significant.

And the idea was to try to put foam on the runway, if you

will, to mitigate the consequences that we were concerned

We knew.

That's what made Lehman systemic.

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1
2

about.
And may I add, I think with respect to the U.S.

Broker Dealer we did in fact mitigate the consequences.

Because remember, on September 16th Barclays came back to

the table, and we were able not only to move those accounts,

but the employees and the business from the U.S. Broker

Dealer to Barclays.

but for that mitigating action by the Fed and the

government.

And the situation would have been worse

COMMISSIONER HOLTZ-EAKIN:

Now I want to ask you

the hypothetical, which is what we ultimately are always

trying to imagine in thinking about this issue of

intervention or not:

Suppose you had had the statutory authority, and

had provided the naked guaranty to the trading for the

Barclays merger, what would have happened in the

marketplace?

WITNESS BAXTER:

Well I think the market would

have reacted well.

been looking to essentially the Fed, the taxpayers, to back

that guaranty.

in the event that there wasn't an affirmative shareholder

vote, in the event that Barclays saw a way out of the deal

that perhaps they didn't like, the American taxpayer would

be on the hook for perhaps hundreds of billions of dollars.

The counterparties of Lehman would have

But as I pointed out in my full statement,

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1

And with respect--

COMMISSIONER HOLTZ-EAKIN:

Would that have been--

but had you had the choice between it, if you had had the

statutory authority, would you have done that instead of

Plan B?

WITNESS BAXTER:

Well the issue is the balancing.

And whenever you approach one of these potential rescues

you're thinking not only legal authority but also the

potential cost to the American taxpayer.

And it has always been, in the 30 years that I

have served the Federal Reserve, part of our orientation

that we have to be good stewards of taxpayer funds.

why we always want to be fully secured.

the Fed is we haven't lost any money.

That is

And the history of

And the problem with stepping in and providing a

naked guaranty in a situation where you can't force deal-

certainty in a merger is it's an enormous risk of taxpayer

funds.

So I realize I haven't answered your question--

COMMISSIONER HOLTZ-EAKIN:

WITNESS BAXTER:

That's correct.

--I think--I think the cost, the

potential cost to the American taxpayer, had we had the

legal authority--and we didn't have it--would have led us to

say that's not something we should do.

COMMISSIONER HOLTZ-EAKIN:

Okay.

Last question.

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1

Mr. Wallison raised it earlier, and it always comes up, the

decision over Bear Stearns.

And my question to you is:

In terms of the process of scrubbing options,

communicating with potential merger partners, communicating

with Bear Stearns, is that process identical for Bear

Stearns and for Lehman Brothers?

WITNESS BAXTER:

In some ways yes.

In some ways

no.

The real risk for the government in this kind of

situation with communicating with potential merger partners

is the risk that that in itself becomes the trigger for the

run; that if the government starts to talk about arranging a

marriage with someone like a Lehman or a Bear, in the eyes

of those it's talking to it is communicating something.

And so that can be the precipitating factor for a

run.

the last possible moment, the point of no return, at least

by the government.

of these.

So in both Bear and Lehman, that was not done until

So that is one common situation in both

With respect to Bear, we only had one suitor and

that was JPMorgan Chase.

real suitors in Bank of America and Barclays.

of America because it went to the next investment bank in

the line--that was Merrill Lynch--and that left us with

Barclays, and Barclays had this problem with the guaranty.

In the Lehman weekend, we had two

COMMISSIONER HOLTZ-EAKIN:

We lost Bank

Thank you,

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1

Mr. Chairman.

CHAIRMAN ANGELIDES:

Thank you.

Before we go to

Mr. Georgiou, can I just ask one quick follow-up to Mr.

Holtz-Eakin's line of questioning to you, Mr. Zubrow.

I want to enter into the record, this is a

chronology of interactions between JPMorgan and Lehman in

the--over the period of 2007-2008, and particularly in those

critical days.

the record.

It's a chronology which I will enter into

But I want to ask you specifically about one

item.

On the 14th, which is that critical Sunday, Mr.

Zubrow, apparently Federal Reserve staff person Parkinson

told our staff that you told him and other Fed officials on

the 14th that JPMorgan Chase would not unwind transactions

and provide intraday credit to Lehman on 9/15 unless the Fed

expanded the types of collateral that could be financed by

the PDCF.

Is that accurate?

WITNESS ZUBROW:

As I responded to Mr. Holtz-

Eakin, we were very concerned that there would not be

investors who would be willing to lend money to Lehman

Brothers on the 15th such that if we did the unwind for the

Broker Dealer on the morning of the 15th, then--

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25

CHAIRMAN ANGELIDES:
collateral--

Right, but they had the

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1

WITNESS ZUBROW:

--we would have the interday

exposure and no one would be there at night to be able to

finance and take us out of that interday exposure.

CHAIRMAN ANGELIDES:

Okay, but let me just

continue this.

Apparently Mr. Parkinson also told the Fed

Board of Governors of your comments, and told Mr. Geithner

to, quote,

trades."

Lehman's collateral, but any triparty collateral."

"tell those sons of bitches to unwind Lehman's

JPMC was, quote, "threatening not only to unwind

Parkinson said, quote, "It would be unforgiveable not to

unwind the triparty."

My question is, for you, you're saying pretty

bluntly here, apparently, they ain't gonna do it on Monday

unless the PDCF collateral is expanded.

on Sunday.

able to provide interday credit on Monday?

that even with that--

But it was expanded

And therefore was that sufficient for you to be

WITNESS ZUBROW:

You're saying

On Monday morning we did the

unwind in a business-as-usual manner--

CHAIRMAN ANGELIDES:

WITNESS ZUBROW:

Okay.

--and extended, you know,

roughly $50 billion--or, actually, I think $86 billion worth

of intraday credit to the Broker Dealer on that Monday

morning.

that the Fed on Sunday night had expanded the PDCF such that

And our decision was based in part on the fact

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1

there was an outlet for investors.

2
3

CHAIRMAN ANGELIDES:
clarity.

Okay.

I just wanted to get

Thank you so much.

All right, Mr. Georgiou.

COMMISSIONER GEORGIOU:

you, gentlemen, for coming today.

Thank you.

And thank

I wanted to try and finish up this point, if I

can.

We are not talking about this whole failure of Lehman

resulting from somebody not checking their fax machine or

something on Sunday.

letter from the Fed reflecting the availability of PDCF

funds went to Lehman on Sunday, but they chose not to

exercise that authority, or to utilize that facility?

14
15

I mean, are you suggesting that this

WITNESS BAXTER:

No, I'm not saying that, because

they did use that facility.

COMMISSIONER GEORGIOU:

WITNESS BAXTER:

18
19

The next day, though.

Yes, and that's what we were

talking about, was the conditions going forward.
COMMISSIONER GEORGIOU:

But, so they couldn't

have exercised it on Sunday?

their-used their collateral to access the PDCF on Sunday?

WITNESS BAXTER:

They could not have accessed

No.

It wasn't available to them

on Friday night, but they were being financed in the

triparty arrangement through the weekend.

that's what Mister--

And I think

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1

COMMISSIONER GEORGIOU:

So that--so that

collateral then was already bound up in the triparty

arrangement over the weekend?

true, Mr. Zubrow?

WITNESS ZUBROW:

Is that right?

Yes.

And is that

The collateral was bound

up in the triparty arrangements over the weekend, and

obviously the markets were closed over the weekend.

8
9

COMMISSIONER GEORGIOU:

Right.

And you would

have continued to bind up that same collateral had you

extended--I take it you used that same collateral on the

Monday, is that right, to extend credit to the Broker Dealer

on Monday?

Is that right?

WITNESS ZUBROW:

That's correct.

COMMISSIONER GEORGIOU:

So really, then, there

wasn't any additional collateral available for the PDCF loan

on Sunday that wasn't otherwise encumbered.

view, Mr. Baxter?

WITNESS BAXTER:

Is that your

I think that the

misunderstanding is, Chase was financing Lehman intraday,

Monday, and then Monday night the Fed came in and financed

Lehman overnight.

22
23
24
25

COMMISSIONER GEORGIOU:

Okay.

And Chase,

JPMorgan Chase had financed them overnight over the weekend?
WITNESS ZUBROW:

So over the weekend, the

investors in the triparty repo mechanism were financing

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1

Lehman Brothers, the Broker Dealer.

the ordinary course of business, there would have to be an

unwind of those arrangements in which Chase would advance

funds to Lehman Brothers such that Lehman Brothers could

repurchase the collateral that they had had tied up over the

weekend--

COMMISSIONER GEORGIOU:

WITNESS ZUBROW:

9
10
11
12

On Monday morning, in

Right.

--from the investors, and the

funds to be able to do that would be advanced by Chase.
COMMISSIONER GEORGIOU:

And you would use what

collateral-WITNESS ZUBROW:

And at that point in time we

would use the collateral that the investors had been using

over the weekend to secure our interday advance.

COMMISSIONER GEORGIOU:

And I guess I need to now

ask Mr. Fuld.

you were going to--did you need additional money on Sunday,

in addition to what had already been provided to you over

the weekend by JPMorgan Chase, that you didn't have, that

they regarded you--no one else--everyone else there regarded

as you not having sufficient collateral to back up?

Did you have--was that the collateral that

WITNESS FULD:

I think there are two different

pieces here.

which is in fact after the fact, which to me is meaningless.

One is the funding for Monday after the fact,

COMMISSIONER GEORGIOU:

Right.

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1

WITNESS FULD:

The real question is:

Did we have

the collateral on Sunday, which I believe is the guts of

your question.

COMMISSIONER GEORGIOU:

WITNESS FULD:

Correct.

Two pools of collateral.

JPMorgan

gets the collateral back from those investors, or triparty

repo partners, that don't want the collateral.

frees that collateral up.

And so that's just a swap of collateral--

That clearly

And then we put it to the Fed.

COMMISSIONER GEORGIOU:

WITNESS FULD:

COMMISSIONER GEORGIOU:

WITNESS FULD:

Right.

--from one institution to the Fed.
Right.

Over and above that, we had

collateral, as evidenced by the fact that we posted $50

billion--I actually found out now it's more than $50

billion, but I'll just settle for the fifty--within the

Broker Dealer.

jump out of the night mysteriously.

So that additional $50 billion just didn't
That was there.

So we had the collateral.

There's another piece, which I would like to

address if I may, which is this question of Fed backing

naked, or unsecured.

balance sheet, 50 percent of it is a match book.

get sold, hived off--

In the first place, $600 billion

COMMISSIONER GEORGIOU:

Right.

That can

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1

WITNESS FULD:

--very easy.

The remaining $300

billion, a lot of it is on-the-run securities, governments,

corporates, equities.

assets.

get too far into the weeds, but those were--those had been

marked so aggressively that a number of people said that if

the rest of the Street had to mark their resi's where Lehman

marked its resi's, there would be a lot of blood on the

Street.

$69 billion of it was less liquid

Of that, close to twenty was residentials, not to

So I look at that twenty and say that that was

okay.

That leaves fifty, $50 billion of less liquid assets.

It's not that they needed $50 billion to collateralize the

trades.

We did a trillion dollars of transactions a day.
The missing piece at the margin is for each of

those transactions, could there have been market volatility

that would have compromised that transaction at the margin.

Not the full face amount.

18
19

COMMISSIONER GEORGIOU:

Obviously, right, some percentage of it.

20
21

WITNESS FULD:

--percentages.

COMMISSIONER GEORGIOU:

WITNESS FULD:

I understand.
You're talking

about--

No, of course.

Okay.

--a tiny fraction of what that

would have been.
COMMISSIONER GEORGIOU:

Right.

Okay.

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1

Understood.

my time on this point, but it seems to me that we don't have

a resolution of this question here.

I just--I mean, I don't really want to use all

I mean, I would hate for us to end this hearing

thinking that because of a bunch of misunderstandings and

mistakes Lehman turned out to be the only investment bank

that had to go down.

8
9

I mean, is that really where we're at here?

was there some other resolution possible on this traumatic

Sunday afternoon after the Fed had acted that could have

rewsolved it, short of the bankruptcy?

12
13
14

And maybe Mr. Miller, do you have a view in this
regard?
WITNESS MILLER:

Yes, sir.

It seems to me that

there was an alternative available.

out, there were other assets that could have served as

collateral.

collateral, but there could have been an alternative to

avoid systemic risk by at least the Fed or the Treasury

standing behind an orderly wind-down of Lehman.

the cataclysmic event of bankruptcy, which produced all

kinds of loss of value.

As Mr. Fuld has pointed

Maybe not under the PDCF standard of

COMMISSIONER GEORGIOU:

Understood.

Instead of

But, okay, I

guess I'm going to leave this because I've already used half

my time, which was not my intent.

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1

I am actually more interested--I mean, it's

interesting why it is that Lehman was not--had to file

bankruptcy and others were rescued.

being Bear, Merrill, Goldman Sachs, and Morgan Stanley, all

of your principal competitors.

interesting question, and I leave it to historians to figure

it out.

8
9

And I guess the others

And that's a nice and

What I think is more fundamental is under what
circumstances you got to the position, Mr. Fuld in your

institution where you needed to be bailed out, or where you

needed some government assistance to survive.

seems to be a more fundamental question for this panel in

connection with this particular inquiry.

And that

Maybe you could address, if you would, what

mistakes you made, what things you would have done

differently to have not placed yourself in a position to

have needed that assistance on that fateful weekend.

WITNESS FULD:

about it:

that.

addressed that.

I clearly made mistakes.

I talked

too much commercial real estate, but we addressed

ratio.

Less liquid assets.
Capital.

We cut by 50 percent.

We got to 11 percent Tier One

So--

COMMISSIONER GEORGIOU:

But you still were, but

even with those actions you still weren't able to secure

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1

adequate credit facilities to operate your business,

correct?

WITNESS FULD:

You are correct, a hundred

percent.

We could not stem the tide of the uncontrollable--

and that's why I talked about it--of the uncontrollable

market forces, and the false rumors that swirled around the

firm.

8
9

And as I also talked about, once a bank is in
seige and loses the confidence in the marketplace, I don't

believe that any bank can exist.

after Lehman, the market lost a ton of confidence.

it right on down the line.

Had it not been for the Fed and Treasury stepping in with

the huge capital injection to put a stiff arm right there to

say, okay everybody, stop; we're behind it, that would have

continued.

And we saw that.

Right
We saw

Morgan Stanley, Goldman Sachs.

Having said that, you asked me another question.

Did we do everything right?

we had too many commercials.

see the depth and violence of the crisis.

contageon.

the assets that we bought, and for the businesses that we

supported.

24
25

We clearly did not.

As I say,

I did not--I, myself, did not
I did not see the

I believe we made poor judgments in timing for

Would I love today to be able to reach back and
take those?

Yes.

Did I say in the very beginning I take

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1

full and total responsibility for the decisions that I made?

I only made those decisions, though, with the information

that I had at the time.

make decisions.

5
6

That's the only way we can ever

COMMISSIONER GEORGIOU:

And we understand that.

But--go ahead.

WITNESS FULD:

I could have, and in retrospect

should have, closed all of our mortgage origination

platforms.

COMMISSIONER GEORGIOU:

WITNESS FULD:

Right.

Instead of doing it in the middle

of '07, I probably should have done it in '05 or '06.

People would have looked at us and said that's a really

irrational move.

ball, I see what's going to happen.

I would have had to say I have a crystal

COMMISSIONER GEORGIOU:

Well in retrospect it

clearly wouldn't have been an irrational move, because that

same difficulty afflicted a whole number of other

institutions that were exposed to those bad mortgage

originations in the first instance, and the multiplication

of those effects that occurred when those mortgages were

told into mortgage-backed securities and collateralized debt

obligations, and CDO-squared, and synthetics, and so forth,

and so on.

I mean, I want to ask you a couple of questions

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1

relating to that that I've harped on through a whole variety

of these hearings.

Do you think that there has been an erosion of

market discipline and market diligence in the origination of

some of these mortgages and the securities based on those

mortgages by the ability of investment bankers like Lehman

Brothers to earn fees at the front end essentially with

regard to the consequence of outlying results with regard to

the origination of those mortgages, or the ultimate

performance of the securities, whether they performed as

represented to investors and so forth?

It seems to me that by earning all your fees up

front, as did the mortgage originators, as did the credit

rating agencies, as did the auditors, and the others that

participated in the offerings, with no reserves essentially

of those revenues against the possibility of failure of

those securities, no clawbacks of the compensation that

resulted from those originations, that all the investment

banks and a whole variety of other institutions were placing

them at risk of failure because their margins were so narrow

with regard to those things that ultimately suffered

significant losses.

Can you speak to that?

WITNESS FULD:

origination business.

We had two parts of our mortgage

One was the actual origination where

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1

we owned the origination platforms.

acted as a conduit, where we went to other mortgage

originators and bought their production.

And the second where we

We believed at the time, very clearly, that we

had proper due diligence for the mortgage origination

platforms that we bought.

management.

of mortgages that we would allow.

securitized mortgages clearly that we thought were safe,

We came in and we changed

We changed the standards.

We changed the types

And we packaged and

given low interest rates, the huge availability of capital

that was in the marketplace, and the individual homeowners'

ability to pay those mortgage payments given those low

interest rates, that those loans were secure.

COMMISSIONER GEORGIOU:

WITNESS FULD:

16
17

Well it turned out now--

They turned out not to be, very

clearly.
COMMISSIONER GEORGIOU:

Right.

And the ratings--

our evidence shows that some 92 percent of the tranches of

mortgage-backed securities that were rated by the agencies

as AAA have been downgraded since.

So I guess--and I suspect that this hearing is

actually probably not the right forum, but let me just ask

one final question, if I could have another minute or two.

24
25

CHAIRMAN ANGELIDES:
and then we'll move on.

Take two, but stay with it,

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1

COMMISSIONER GEORGIOU:

The focus here is on the

question of too big to fail.

Your principal gripe here, if

I could say that, today Mr. Fuld is that your institution

was the one that was permitted to fail, and just about

everybody else that you either did business with or competed

with was permitted--was rescued, or assisted in some

significant instance to continue to survive, or some merger,

assisted merger was negotiated.

But isn't the fundamental question I guess under

what circumstances any institution ought to be permitted to

fail?

have been the rare instance when there was a rescue, and not

the rare instance that there wasn't a rescue, as was the

case with your institution.

us your views whether and under what circumstances the

government ought to place taxpayer funds--utilize taxpayer

funds to assist institutions like yours?

18
19

I mean, some might argue here that really it ought to

WITNESS FULD:
"permitted" or "allowed."

And do you--can you share with

First off, it's not that we were
We were "mandated."

COMMISSIONER GEORGIOU:

Well you had no choice.

Unless somebody gave you the lifeline, you had to--

bankruptcy was your option, basically.

I mean, I'm looking at Mr. Miller and he's nodding his head.

24
25

Is that not right?

I mean, I don't know what else you could have
done.

You couldn't have opened for business on Monday

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1

morning.

WITNESS FULD:

COMMISSIONER GEORGIOU:

WITNESS FULD:

If we really had access-Pardon?

If we really had had access to

that window as described, I can't tell you Lehman was--

COMMISSIONER GEORGIOU:

But that would have been

taxpayer dollars.

I'm saying that in the absence of

extension of that lifeline by the taxpayers, your option was

to file bankruptcy, which you did, with all the consequences

to your shareholders, and creditors, and the system, and so

forth.

Correct?

WITNESS FULD:

Correct.

COMMISSIONER GEORGIOU:

Okay, now the question I

guess I'm asking you is:

to happen in the basic capitalist system that we all operate

under?

17
18

WITNESS FULD:

Don't you think that's what ought

Unfortunately I'm going to give

you a convoluted answer, and I'll apologize to begin with.

Capitalism works--

CHAIRMAN ANGELIDES:

If you could do this for us,

just because of time, try to give it as brief as possible

and follow up with a longer written answer.

convoluted, but try to hit it hard.

WITNESS FULD:

I apologize.

I know it's

Capitalism works

within a finite range of standard deviations of volatility.

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1

When I talk about uncontrollable market forces, we were way

outside.

Had the Fed totally ignored everything, Treasury

ignored everything, in a pure capitalistic free market 'let

it happen as it falls,' not only would you have lost Lehman,

Morgan Stanley quickly, and Goldman Sachs thereafter.

What other countries did, very quickly, they

stepped in.

going to stop this irrational sense of panic and put

We're guaranteeing.

COMMISSIONER GEORGIOU:

Okay.

Well, I'm going

to--

CHAIRMAN ANGELIDES:

WITNESS FULD:

COMMISSIONER GEORGIOU:

We're

confidence back into the marketplace.

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12

They said, no more.

there.

Well, let's--

--that would have-Well let's leave it

I mean--

VICE CHAIRMAN THOMAS:

Commissioners who I think will--

There are other

COMMISSIONER GEORGIOU:

That's fine.

I mean,

obviously if there's other time at the end I'd like to

follow up, but that's fine.

much.

Thank you.

CHAIRMAN ANGELIDES:

COMMISSIONER HENNESSEY:

VICE CHAIRMAN THOMAS:

Thank you, very

Mr. Hennessey.
Thank you, Mr. Chairman.

Mr. Chairman, at the

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beginning could I yield the gentleman five additional

minutes, so you've got ten to work with and we don't have to

play the time game.

COMMISSIONER HENNESSEY:

Thanks.

Based on your

testimony and other things I've heard, I think I want to

stipulate that there was a liquidity run, even though there

may be differing views as to why there was a liquidity run.

And it sounds like sometime around the 8th or 9th of

September, you have Fannie and Freddie, and then shortly

thereafter you have this whole sequence of events.

I'm interested in the time before that.

before the liquidity run begins.

that I see from all the different stories, from all the

different elements of testimony and the staff work that

we've seen, is that Lehman invests too heavily, especially

in commercial real estate in '06 and '07.

of '08, you--sometime in the late '07, early '08, you

recognize this and you start to address it.

And, Mr. Fuld, the story

At the beginning

You start to wind down your various portfolios

where you're too highly leveraged.

go out and you start raising equity capital.

got a problem and you're working as quickly as you can to

solve it.

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25

I think after Bear you
And so you've

In the post-Bear world, there are questions being
raised by counterparties and others in the market as to

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whether what you're doing is sufficient.

several times:

solve the problem.

You've said

Look at all the things that we were doing to

I haven't herd anyone dispute that you were

taking aggressive actions.

I've been reading people saying we're not sure if it's

enough; we're not sure if the firm is still healthy.

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9

I have heard people saying, and

Now in your testimony you say there was no
capital hole at Lehman Brothers.

other three here.

I want to start with the

hole at Lehman Brothers?

Pre-liquidity run, was there a capital

Mr. Miller, I saw you saying of course Lehman's

challenges were very serious.

deficiency, liquidity drain, and a low level of market

confidence.

They suffered from capital

Mr. Zubrow, I've heard you talking about your

liquidity concerns and the counterparty right in those final

days.

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20
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Let me start with you.
Did JPMorgan have solvency concerns about Lehman

before this liquidity run began?
WITNESS ZUBROW:

As I've said in my written

testimony and in the oral testimony, one of the things that

we focused with all of our triparty repo clients going back

to the Spring of '08 was our concern about the composition

of those books, the character of the assets that were being

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financed on an overnight basis, and whether or not there was

appropriate haircuts being applied by investors to reflect

the character of those assets.

And so I think that it is clear that throughout

that whole period there were a number of concerns that we

were raising with our broker dealer clients in general, and

Lehman Brothers in particular, about the character of their

financing, and that obviously, you know, magnified itself as

we went through towards the end of the Summer and the

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beginning of September.
COMMISSIONER HENNESSEY:

I'm going to cut you off

because my time is limited.

that April to August time period and ask you privately, do

you think Lehman is solvent, what would you have said at

that point in time?

Yes?

WITNESS ZUBROW:

If I could go back in time into

No?

Or I'm not sure?

I think that Lehman clearly had

capital at that time that was supporting its businesses.

from a pure accounting standpoint, it was solvent.

obviously was financing its assets on a very leveraged basis

with a lot of short-term financing.

that--our own view, from a credit standpoint would be that,

you know, they had a very thin, you know, cushion of error

with the way they were financing their balance sheet and

what the character of the assets were on the balance sheet

and the way they were being financed.

But it

So I do not think

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COMMISSIONER HENNESSEY:

Mr. Baxter, do you have

a view on this?
WITNESS BAXTER:

First, the Fed was not the

supervisor of Lehman.

COMMISSIONER HENNESSEY:

WITNESS BAXTER:

Understood.

But one of the lessons of the

crisis for us is that there wasn't enough capital in the

banking system, either, to withstand the kind of effects

that we felt in 2008.

COMMISSIONER HENNESSEY:

I'm trying to figure out

whether the liquidity run in fact may have had some

substantive justification because the marks were bad, or

their balance--you know, maybe Mr. Fuld was wrong.

they didn't have sufficient capital before the run started.

Do you have a view on that?

WITNESS BAXTER:

Maybe

Well where I was going with that

is, I think one of the things we learned during the crisis

is that there needed to be more capital to withstand this

kind of shock.

the nine major financial holding companies were urged in a

meeting at the Treasury to raise more capital.

And that's why on Columbus Day of 2008 that

And then as we went into 2009, the Fed led the

Supervisory Capital Assessment Program, which developed a

capital buffer to come on top--

COMMISSIONER HENNESSEY:

Understood, but that's

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after the fact.

I know your answer, which is there wasn't a capital hole.

Why did you have such a tough time convincing others that

your accounting was good, that you were sufficiently

transparent, that your marks were good, and that the firm

was viable?

I'm trying to figure out--Mr. Fuld, I think

Why was the decreasing confidence?

The Valukas

Report specifically is citing the two consecutive quarters

of lost earnings, and then is talking about market

participants raising concerns about your marks and about

your transparency.

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13
14

Can you talk about that from your perspective,
pre-mid September?
WITNESS FULD:

First quarter, typical quarter, I

believe we were positive net income of about $500 million.

That was shortly after--I think we reported shortly after

Bear Stearns.

With Bear Stearns there had been a huge number of

rumors, and I know nobody likes to hear about naked

shortsellers, but I believe that there are enough

institutions that suffered from naked shortselling, and

there's been a ton of testimony around that that you don't

need to hear it from me, there is no coincidence about stock

price performance and naked shortselling.

that alone.

I'll just leave

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We were the next smallest.

I think there were a

number of rumors, incorrect rumors, that talked about mark-

to-market, talked about misrepresentation of certain assets.

There were some hedge funds that talked about mortgage CLS

and CDOs that we were carrying on the balance sheet that we

weren't disclosing.

We went to full disclosure.

mortgages.

corporate asset-backed financings.

They were not

They were not real estate related.

They were

We went live with that.

We dug deeper into our explanations and were even more

transparent.

That did not resolve it.

And once you get a bank on the run having to

defend itself time and time again, you lose--not "you,"

"we"--we lost credibility.

Why was I not able, or why were we not able to put a stake

in the ground and say this is where we are.

let's go on.

You're asking me a question:

Believe it, and

And I do not know.

Because we did have a number of analysts.

We did

have the agencies--the agencies had their own problems--come

out and say why was Lehman a single A.

billion in writedowns.

liquidity.

businesses.

They had taken $25

They had the capital.

They had the

And they had a strong set of operating

I do not know.

COMMISSIONER HENNESSEY:

Okay, let me then follow

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up--

WITNESS FULD:

I do not know why we were unable--

3
4

COMMISSIONER HENNESSEY:

Two questions.

I assume

we agree that post-bankruptcy filing there was a capital

hole?

8 or 9 cents on the dollar.

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9

I mean, the senior unsecured debtholders were getting

WITNESS FULD:

It wasn't post-bankruptcy.

It was

within six hours.

COMMISSIONER HENNESSEY:

Okay, but your argument

then is that that was entirely the result of the liquidity

run?

WITNESS FULD:

It was taking our entire

derivatives swap structured transaction book.

owed us money, because of bankruptcy didn't have to pay.

Those that had collateral didn't have to return it.

that only heightened the crisis, because what they did was

they sold out collateral, which meant that there were more

assets in the marketplace looking for a new home, which

further depressed prices.

COMMISSIONER HENNESSEY:

Okay.

Those that

And

I want to come to

one other point.

aside, the rumors, the whisper campaign that's out there to

talk down Lehman--those are my words, not yours--from our

perspective we heard a similar story from the former heads

The point which you said you sort of set

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of Bear Stearns:

there was no reason for people to stop providing us with

liquidity; but there were people out there whispering.

We were a fundamentally solvent company;

And I'll just say from my perspective it is a

plausible story that there are people out there talking down

the value of the firm.

people who would do that, for whatever reason.

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9

I'm happy to believe that there are

Until and unless someone is able to actually
point to someone and accuse them and say, I think this

person was doing it, what's going to happen is we're going

to spin round and round like we always have done.

someone like you will assert there are people who were

trying to bring down my firm by whispering lies about it,

and then the investigators, whether it's the SEC or somebody

else, will say, well, we went around and talked and we

couldn't find anybody.

Which is,

So setting aside and saying there are unnamed

people out there who are spreading these rumors doesn't help

convince at least me that that's the case.

and say here's a hedge fund manager who was talking down my

firm, so that someone with the subpoena authority, whether

it's this Commission or the SEC, can go after them and say:

What did you say about Lehman Brothers?

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25

Point to someone

I want to come now to the question of the weekend
and the bridge loan.

And the bridge loan that you were

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looking for, the bridge funding that you were looking for,

that was a bridge to what?

What we have heard from Mr. Baxter, what we heard

from Mr. Alvarez, what we've heard from then president

Geithner, and Chairman Bernanke, and Secretary Paulson, is

that the problem is there wasn't a buyer.

Korean Development Bank, which said no.

through.

Baxter was wrong.

Barclays fell

So, suppose that Mr.

Suppose there was some legal path to

provide you with short-term financing.

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12

BofA went with Merrill.

There was the

What would that have bought you time to do?

Who

was going to be your partner?

WITNESS FULD:

BofA clearly was not.

Barclays

remains to be seen.

pre-release our earnings on September 10th, whatever it was.

That was about 10 days to 2 weeks earlier than we had

planned.

Please remember that we were forced to

We were having a number of conversations--when I

say "number," I don't mean two or three, I mean closer to

eight or nine--with potential capital providers, or larger,

to support the firm.

Even KDB was literally on its way to New York on

that Wednesday of that week, whatever it was, September 7th,

8th, 9th, and 10th, when they were called back by their

Finance Minister.

They were on their way to see us.

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Nomura subsequently stepped in.

I can't look at

you today and tell you I had two or three people that would

have bought the firm.

to prove otherwise.

I can't do that.

position where, had we gotten through that Sunday, we would

have been able to have had at least an orderly wind-down.

It may have wiped out a good part of the equity value; I'm

not sure of that.

All conjecture.

You wouldn't be able

But you asked me a question.

My view.

But at least we would have been in a

I believe it would have protected the creditors

and debtholders; would have held in place the derivatives,

swaps, and structured transactions; and also, may have

given--"may"--have given us an opportunity to have then

consummated a transaction which would have taken Lehman into

somebody else's corporate forum--that was ridiculous--a

merger.

COMMISSIONER HENNESSEY:

way I'm hearing it, the Fed guys are saying:

didn't see any possible buyer out there.

and Barclays fell through, there was nobody there lined up,

and that's why this was fundamentally different from

JPMorgan and Bear Stearns, why it was fundamentally

different from Citi and Wachovia.

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25

Okay, and just from the

What I hear you saying is:

Look, we

Right?

After BofA

Fed, give us some

time, at a minimum to wind down in an orderly manner, and

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maybe someone else will be out there to buy it.

That second

part, that "maybe somebody will be out there to buy us,"

sounds consistent with what the Fed guys are saying, which

is that over the course of that weekend there wasn't a

buyer.

There wasn't a viable candidate.

So if from their perspective the entire sphere of

government action was contingent on there being a potential

buyer out there, it sounds like the two of you agree that

over that weekend there wasn't.

The clock ran out on you.

The liquidity run was in place.

You didn't have a buyer.

And if you believed the Fed's perspective, they're saying we

don't have a legal authority to do it.

saying, well, maybe there was some other motivation.

Can you comment on that?

WITNESS FULD:

CHAIRMAN ANGELIDES:

VICE CHAIRMAN THOMAS:

And others are

minutes.

All right-Why don't we go ahead and--

He's had ten.

CHAIRMAN ANGELIDES:

VICE CHAIRMAN THOMAS:

I've given him five more

Okay.
One minute to finish up on

the response.

COMMISSIONER HENNESSEY:

VICE CHAIRMAN THOMAS:

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25

Two minutes?

Two minutes to finish up

on the response.
CHAIRMAN ANGELIDES:

Which would make it four

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1

minutes.

We're fine.

VICE CHAIRMAN THOMAS:

Two minutes.

COMMISSIONER HENNESSEY:

WITNESS FULD:

Thank you.

I believe we did have a buyer in

Barclays.

I believe they did want the entire entity.

believe that they wanted to hive off certain assets, and I

believe our competitors had put together a consortium to

have financed those assets.

buyer.

So I believe we did have a

We needed some pieces of assistance, but I believe

we had a buyer.

can tell you that, I said it before, we were having four or

five other conversations.

Nomura stepped in 24 hours later.

It wasn't just a buyer.

And I

It was a potential

capital provider, because the question was did we have the

capital to fund SPEDCO, which was SEC-approved?

did.

the same capital that was supporting those commercial real

estate assets on our balance sheet.

Yes, we

Because the capital that would have gone to SPEDCO was

So, yes, we did.

We had internal capability to create capital:

change the preferreds to common, bring down the balance

sheet.

whatever it was $10 billion of capital.

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24
25

So we had other opportunities to create $7 to

Any one of those would have bridged that gap.
Some internally created, some external.
COMMISSIONER HENNESSEY:

Okay.

One other--I

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think I'll finish with a comment here, which is:
On the extensive amount of time we spent with Mr.

Alvarez and Mr. Baxter debating whether the Fed's nonaction

was a choice, or was the only option that they had, I think

that there is a burden upon those who argue that it was a

choice to describe what the other option was.

that other option is the "who was the buyer?" option; but

the other piece of it that I have not seen is:

other legal path?

And part of

What was the

I have still not seen in the, what, two years

since this happened, any lawyer describe:

Baxter's job, here's what I would have advised the president

of the New York Fed to do.

he could have used to provide this stream of funding to

either the broker-dealer, or the holding company pre-

bankruptcy filing to then facilitate the transaction here.

If I had had Mr.

Here's the legal authority that

For there to be a choice, there have got to be

two options.

some people say there may be nefarious motives about what

that option was, but until someone describes the other

option, there isn't a choice.

I've heard one option described.

I've heard

And I'm still waiting for someone to tell me what

was that other option that president Geithner and Chairman

Bernanke supposedly rejected.

VICE CHAIRMAN THOMAS:

I want 15 seconds.

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CHAIRMAN ANGELIDES:

All right, thank you.

just have one, though, comment, which is I don't think

anyone has implied nefarious motives.

trying to get to is what exactly happened, why it happened,

why the decision was made.

I think what we are

Obviously the Fed has their position.

They've

stated it well.

There's information we have which people

can review and come to their own conclusions about.

we're just trying to get to what happened.

VICE CHAIRMAN THOMAS:

CHAIRMAN ANGELIDES:

I think

Just a quick--

And the only thing I might

add on that, and I'm not--I'm saying I'm trying to find out

what happened.

chronology, since you raised this.

I see a number of motivations at work in the

I also note that on September 23rd and 24th, when

Chairman Bernanke was called before Congress to talk about

the Lehman failure/bailout, legal authority was never

mentioned in that testimony.

that the chronology seems to indicate multiple item

considerations at work, and that was my only point.

So I just wanted to point out

Now, Mr. Vice Chairman.

COMMISSIONER HENNESSEY:

at some point, after the Vice Chairman?

VICE CHAIRMAN THOMAS:

CHAIRMAN ANGELIDES:

Could I respond to that

We'll see.

You're in your mother's

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arms.
VICE CHAIRMAN THOMAS:

All I want to do is

underscore from the first panel the comments from

Mr. Corston about his concern was focused on the FDIC, and

not having the FDIC at risk in terms of its Fund.

that's why with Wachovia they were more than pleased to have

the Treasury issue a change in a tax provision which gave

them an out that didn't cover them.

And

Mr. Alvarez also made the point that the Fed

wasn't exposed, so that was a pretty good deal.

to thank you, Mr. Baxter, for three times mentioning that if

they had only had access to additional funds, A, B, or C

would have occurred.

additional access to funds, D, E, or F would have occurred.

I just want

And then if they had only had

You said that you couldn't sustain the taxpayer

exposure to allowing additional time to see if something

else could happen.

appreciate your understanding that whatever euphemism is

used, "government," "FDIC," "Federal Reserve," it's all the

taxpayers' money.

So on behalf of the taxpayers, I want to

And at some point, if that was going to be a

relief to give you the ability to do something else, you

just ran out of time.

out of dollars.

And the taxpayers have certainly run

CHAIRMAN ANGELIDES:

Thirty seconds.

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COMMISSIONER HENNESSEY:

CHAIRMAN ANGELIDES:

3
4

Thirty seconds.

Then I would like to move

on, yes.
COMMISSIONER HENNESSEY:

Just to respond to your

point, I agree that it is important to understand all the

motivations of all the actors involved.

issue, I think the legal question is dispositive.

8
9
10

On this particular

We have Mr. Baxter and Mr. Alvarez who are
testifying under oath that they believed there was only one-there were only these particular legal paths.

CHAIRMAN ANGELIDES:

Let's do this--

COMMISSIONER HENNESSEY:

CHAIRMAN ANGELIDES:

If they are in fact--

You and I can debate this,

and we'll have a lot of time between now and December to

discuss this.

legal opinion from Mr. Alvarez.

And why don't we just--I understand your point.

I'm just going to observe that there's a
There's facts on the table.

I said, as one member of the Commission, we put

facts on the table.

And I think part of our job is to

digest those, but also let the public digest those.

COMMISSIONER HENNESSEY:

CHAIRMAN ANGELIDES:

COMMISSIONER GRAHAM:

Thank you.

Yes.

Senator Graham.

Thank you, Mr. Chairman.

would like to ask my first question of Mr. Baxter, not

individually but as a representative of the New York Fed.

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Has there been an evaluation made of the

consequences of the failure of Lehman?

WITNESS BAXTER:

I think not just by the New York

Fed, I think we all in the Federal Reserve understand that

the Lehman bankruptcy had significant consequences and was

one of the accelerants for what we experienced in the last

quarter of 2008.

COMMISSIONER GRAHAM:

And is there a written

document, either from your office, the New York Fed, or some

other place that puts some numbers behind the consequences?

WITNESS BAXTER:

None comes to mind,

Commissioner, but let me go back and check with my

colleagues.

to the Commission.

15
16

If there is such a document, we will provide it

COMMISSIONER GRAHAM:

Mr. Miller, do you know of

any evaluation of the consequences of the failure of Lehman?

WITNESS MILLER:

VICE CHAIRMAN THOMAS:

WITNESS MILLER:

No, sir, nothing in writing-Your mike.

No, sir, there's nothing in

writing that I have seen.

CHAIRMAN ANGELIDES:

WITNESS MILLER:

About the bankruptcy?

The bankruptcy has had severe

consequences for the creditors, and the stockholders, and it

has ancillary waves of problems for the companies that were

relying upon financing from Lehman who ended up in

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bankruptcy.

COMMISSIONER GRAHAM:

I mean, the whole rationale

for governmental intervention is that there are consequences

to failure that are not only unacceptable to the institution

directly involved, but to the larger financial and economic

community.

This seems to be the most significant case study

to test that theory.

So I would think someone would have

done an analysis of what were the consequences of the

failure of Lehman as a means of evaluating the seriousness

of the consequences of nonintervention in other analogous

cases.

I am particularly interested in the future.

And

that is, what can we do in order to avoid getting into this

Sunday night situation with future institutions?

We had a list of items from the earlier panel as

to what has been done through things like the Dodd Act, and

one of those was to enhance risk management standards.

Mr. Zubrow, as the risk manager for one of

America's largest financial institutions, what have you done

to enhance risk management since September of 2008?

do you anticipate being done?

WITNESS ZUBROW:

Or what

First of all, Commissioner, I

would note that obviously throughout the crisis we feel that

JPMorgan Chase performed extremely well.

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We had the benefit of what we think was very good

risk management practices, you know, that started with a

very strong risk culture and tone at the top.

question that, you know, leading up to the crisis, you know,

we made some mistakes, and there are things that, you know,

we have certainly changed in terms of the way we think about

risk management.

8
9

There's no

As I look forward, I think that some of the most
important things that people have to focus on in large

complex institutions is making sure that there's a

comprehensive risk culture in the institution.

culture has to start with a very strong tone at the top,

from both the CEO and the board and percolate throughout the

whole organization.

comprehensive, you know, measurement devices to be able to

assess what the risks are that the institution is taking to

measure them, to monitor them, and to obviously mitigate

those risks that are deemed to be excessive.

That risk

And there has to be the right

COMMISSIONER GRAHAM:

In your corporate

governance structure, is risk management a responsibility of

the audit committee?

board that has a broader responsibility for risk management?

Or is there a separate entity of the

WITNESS ZUBROW:

There's a separate committee of

the board.

you know, I certainly feel that I'm accountable to that

It's our Director's Risk Policy Committee.

And,

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Committee.

Obviously I report directly to the CEO, but in

addition the entire Risk Management organization of the Bank

reports to me, is independent of the different lines of

business that they monitor or control, and that independence

is a very important part of the type of risk culture that I

talked about.

8
9
10

COMMISSIONER GRAHAM:

You've said, and I believe

there is external support for this, that Morgan Stanley has
had a reputation for a strong risk management process--

WITNESS ZUBROW:

I believe you mean JPMorgan?

COMMISSIONER GRAHAM:

JPMorgan.

I mean JPMorgan, I'm sorry,

augment your risk management?

But do you anticipate any changes to further

WITNESS ZUBROW:

We certainly constantly review

how we do risk management in our different businesses.

There are certainly things that we've changed.

One of the things that we've certainly emphasized

over this period of time is greater stress testing, not only

of our trading books but also of our other lending books.

We certainly have changed a number of the limit structures

under which we allow our businesses to operate.

And so we view risk management as very much of an

evolutionary process.

past, both ours as well as others'.

We try to learn from mistakes in the

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COMMISSIONER GRAHAM:

Mr. Fuld, you listed some

of the mistakes that you thought Lehman had made.

hazard the sense that there would be an ultimate

governmental support if things went as bad as they

ultimately did, was that part of the mistakes of Lehman

Brothers?

Was moral

What was your level of expectation that you were

going to have government assistance in the extremis

situation?

WITNESS FULD:

I had no expectation that the

government would help us.

was set after Bear Stearns, where there was so much lashback

on bailout, and crisis, that it was clear that the

government could not do that again.

And I think that that precedent

So I walked into not only that weekend but also

the month before knowing that we had to create our own

solution.

COMMISSIONER GRAHAM:

One of the other items you

raised was your mortgage origination operation.

By the mid

part of the last decade there were some signals that

residential mortgages were weakening.

acceleration of housing values had stalled, and then started

to decline.

The pace of

Some of the ratings--

CHAIRMAN ANGELIDES:

Two minutes, Senator?

COMMISSIONER GRAHAM:

Could I have thirty

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1

seconds?

CHAIRMAN ANGELIDES:

COMMISSIONER GRAHAM:

Yes.
Do you think that--why

didn't Lehman become aware of this decline in its

residential mortgage asset portfolio earlier than you

indicated it did?

WITNESS FULD:

I said that we closed our

platforms in the middle of '07.

COMMISSIONER GRAHAM:

WITNESS FULD:

Yes.

Toward the latter part of '06, we

began to hedge our mortgage positions.

it in our 2006 filing to indicate that we had started to

hedge those positions.

And even spoke about

At that point, though, I did not believe that it

was going to escalate to the point that it did.

But even in

the early part of '07, we began to cut back on the

commitments that we made to securitize.

closed the platform altogether.

COMMISSIONER GRAHAM:

WITNESS FULD:

And then eventually

Thank you.

So it went in a chronology of '06

hedging, '07 cut, early '07 cutback, securitizations, mid-

'07 close the platform.

COMMISSIONER GRAHAM:

CHAIRMAN ANGELIDES:

Thank you.
All right, thank you.

Very

quickly members, we have received a copy--and I guess we

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could make a copy for all the members--of the letter to

which Mr. Baxter has referred.

Baxter said there was a letter offered on September 14th

which made it clear that the expanded collateral was

available to Lehman Brothers.

Baxter might refer to as "the smoking letter."

As you may remember, Mr.

This is what I think Mr.

Mr. Holtz-Eakin has a couple of questions on this

letter, and some information from the Valukas Report.

think it would be helpful to inform the members here.

COMMISSIONER HOLTZ-EAKIN:

VICE CHAIRMAN THOMAS:

Does Mr. Baxter have a

COMMISSIONER HOLTZ-EAKIN:

Mr. Baxter is welcome

to mine.

VICE CHAIRMAN THOMAS:

COMMISSIONER HOLTZ-EAKIN:

Just briefly.

copy?

13
14

Is your memory that good?
It doesn't matter.

I'm not going to read from the letter.

VICE CHAIRMAN THOMAS:

COMMISSIONER HOLTZ-EAKIN:

The only question--

Let him have it.
The copy we have--take

one down--the copy we have shows no acknowledgement of

receipt by Lehman.

actually got it, we would like to see that.

the file somewhere of someone.

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25

If you've got a copy that shows they

WITNESS BAXTER:
obviously--

It must be in

We will look. I don't,

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COMMISSIONER HOLTZ-EAKIN:

WITNESS BAXTER:

COMMISSIONER HOLTZ-EAKIN:

4
5

that's for later.

Thank you.

--have it with me.
I know.

I mean,

Here's what I want to understand.

This is from the Valukas Report, and it says that

on the 14th the Federal Reserve issued a press release

stating the expansion of collateral pledged at the PDCF,

letter informs recipients of that, and then, quote:

Upon learning of the expansion of the PDCF

window, Lowitt and Fuld initially believed that Lehman's

problem was solved and that Lehman would be able to open in

Europe by borrowing from the PDCF.

learned that it was not eligible to use the window.

Federal Reserve Board Bank of New York limited the

collateral Lehman Brothers could use for overnight financing

to the collateral that was in Lehman Brothers box at

JPMorgan as of Friday, September 12th, 2008.

restriction was referred to as 'the Friday criterion.'

the source of the Friday criterion information is in fact

the same Christopher Burke who is the author of this letter.

WITNESS BAXTER:

The

That
And

Is that correct?

However, Lehman soon

I have met with Mr. Valukas in a

trip to Chicago in June to talk about this issue with

respect to--this and other issues with respect to the

letter, and I don't have an answer as to, you know, to

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clarify, other than the letter seems to speak for itself.

I, you know, have the utmost confidence, and I

think the Valukas Report is an excellent report.

That

doesn't mean that I think every single detail is correct.

And this is one of those details that I think our record and

the record of Mr. Valukas are different.

reconcile those differences for you.

And I can't

I will go back and see whether we can come up

with our best understanding as to explaining this, but I

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11

don't have an explanation right now.W
COMMISSIONER HOLTZ-EAKIN:

We don't have time

right now, but I would ask, very much, that you would not

just give your best effort, but please reconcile the various

accounts of what was eligible to be pledged by Lehman prior

to their filing at 2:00 in the morning on the 14th.

CHAIRMAN ANGELIDES:

What I would like to do,

with your permission, Mr. Holtz-Eakin, is to enter the

letter into the record, and the relevant portion of the

Valukas report, if there's no objection.

And the only other thing I want to put a

punctuation mark on is the last sentence you read was

attributed to the Examiner's interview of Mr. Burke.

this was not the Examiner.

of Mr. Burke.

This is the Examiner's interview

So we will follow up at the staff level, or the

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staff will follow up at the staff level, on this issue.

right, thank you.

Ms. Born.

COMMISSIONER BORN:

All

Chair.

Thank you very much, Mr.

And I'd like to start by asking Mr. Baxter a

question.

You testified that the Federal Reserve, at least

the Bank of New York but I think you meant the entire

Federal Reserve Board, was aware in the runup to the Lehman

Brothers bankruptcy that Lehman Brothers was systemically

important, and that its failure would have systemic negative

effects?

Is that correct?

WITNESS BAXTER:

That's correct.

COMMISSIONER BORN:

And you also said that one of

the things you were aware of was that it's failure would

cause disruptions in the derivatives market.

correct?

WITNESS BAXTER:

COMMISSIONER BORN:

Is that

Yes.
Were there disruptions in the

derivatives market when Lehman Brothers failed?

WITNESS BAXTER:

Yes.

COMMISSIONER BORN:

WITNESS BAXTER:

What were those disruptions?

Well I'm probably not the best

person, being a lawyer, to describe them for you,

Commissioner Born, but I do understand that there were

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problems with netting arrangements.

occurred also because of what we were trying to deal with

during this most extraordinary week.

Some of those problems

Remember that on September 16th we had a problem

with AIG as well.

what was effect, particularly at that point in time.

this is another very significant point with respect to

causation.

So it's hard to say what was cause and
And

The month begins with a conservatorship of Fannie

Mae and Freddie Mac.

15th.

September 16th.

after Lehman weekend, Morgan Stanley and Goldman Sachs

become bank holding companies.

Then we have Lehman file on September

We have an extraordinary event with respect to AIG on
And then to cap it off, on the weekend

So, you know, an extraordinary series of events

in a short series of time.

all markets, including the derivatives market.

hard to say that it was the Lehman that caused that

disruption rather than one of the other many events that we

were trying to deal with, many of the other fires that were

burning at the time.

There were disruptions across

COMMISSIONER BORN:

So it's very

Are you aware of any studies

or reports or information at the Fed, or another government

agency, dealing with the disruptions in the derivatives

markets at that time?

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1

WITNESS BAXTER:

I believe there are reports.

can't cite you the economist who wrote them at this

particular point in time, but let me go back and see if we

can identify them and make them available to the Commission.

COMMISSIONER BORN:

and I request that you do so.

That would be very welcome,

We have had some people tell us that the Lehman

Brothers failure did not in any way involve problems with

derivatives; and that that was an illustration of how small

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11

a role derivatives played in the financial crisis.
So I wanted to ask Mr. Miller whether or not

there were problems or concerns with derivatives involved in

the bankruptcy of Lehman Brothers, to your knowledge.

WITNESS MILLER:

Yes, there was, and there

continue to be major problems with unwinding derivatives

transactions.

was to create an event to default under--most of these

derivatives were under, is the contracts.

the event of default, the counterparties were entitled to

give notice of termination.

The effect of the filing on September 15th

And because of

And from Friday to Monday, as I understand,

Lehman was in the money.

15th, Lehman was out of the money.

counterparties gave notice of termination, proceeded to

liquidate collateral, and because of the provisions in the

And when we got to the week of the
And many of the

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1

Bankruptcy Code a bankruptcy court has no jurisdiction over

that.

In 2005, Congress passed legislation which safe-

harbored all these transactions.

substantial losses in connection with the derivatives

markets.

estate in terms of personnel, even to this day, involves

trying to unwind the still-remaining derivative

transactions.

So Lehman took very, very

And a major portion of the administration of the

There are over almost 250 people who work on the

Lehman Estate who work on nothing but derivatives.

transactions are extremely complex.

There all all types of transactions.

area.

15
16

These

They're multiple.
It's a very complex

And it's all interconnected all across the globe.
COMMISSIONER BORN:

Interconnections among

financial firms?

WITNESS MILLER:

all of the Lehman global operations.

because of the bankruptcy of Lehman Holding, within 10 days

we had 80 foreign proceedings.

proceedings has either a receiver, or an administrator, and

the very major operation in London, Lehman Brothers Europe,

which was one of the biggest broker-dealers in London, when

that entity went into administration under the UK Insolvency

Laws, and administrators were appointed from PWC, the first

Yes, ma'am.

Financial firms in

On September 15th,

And every one of those

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1

thing they did was close down the system, the accounting

system.

That accounting system, which was a global

system, operated excellently while Lehman was operating.

closing down the system, we lost track of all the

transactions.

and reporting system.

8
9

And we had to re-create the entire accounting

So to this very day, derivatives remain a very
big part of the administration of the Estate.

COMMISSIONER BORN:

Is there any document that

you are aware of that describes in detail the problems of

derivatives in the Estate?

WITNESS MILLER:

I believe that the International

Society of Derivatives Association has done a number of

studies on the effect of not only Lehman's bankruptcy, but

generally the contraction in the markets.

have been a number of reports that it has prepared.

18
19

COMMISSIONER BORN:

Do you have any of those

reports?

20
21

I think there

WITNESS MILLER:

I'm sure we can have access to

it.

COMMISSIONER BORN:

It would be very valuable if

you would try and get access to those and provide them to

us.

WITNESS MILLER:

I will do so.

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1

COMMISSIONER BORN:

Mr. Zubrow, let me just ask

you a question, since JPMorgan was a major counterparty,

derivatives counterparty, as well as the triparty repo

clearing bank for Lehman Brothers.

In your testimony you indicated that Lehman

Brothers had asked--that JPMorgan had asked Lehman Brothers

for $5 billion in extra collateral on September 9.

said that a primary reason for that was because of

JPMorgan's derivatives exposure related to Lehman Brothers.

And you

Could you explain what that exposure was?

kinds of things did that consist of?

WITNESS ZUBROW:

What

As I said in my testimony, both

written and oral, there were two--several primary sources of

our credit exposure to Lehman.

triparty repo book that we've talked about.

One was obviously the

In addition, in order for us to continue to be

supportive of Lehman in the marketplace we would be taking

on derivatives exposure either by directly trading with

Lehman, or trading on behalf of prime brokerage clients.

And then in addition, many counterparts of Lehman

during that week sought to close out their derivatives

positions with Lehman and extinguish any credit exposure

that they might have in the failure of Lehman, and they

would come to us and ask us to step into their shoes in a

process that's called a novation.

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1

And in order for us to continue to be supportive

of Lehman in the marketplace, to continue to accept those

novations, to not back away from them as a counterpart, we

asked for that additional collateral.

5
6

COMMISSIONER BORN:
one very--

7
8

And did you consider--just

CHAIRMAN ANGELIDES:

Sure.

Absolutely.

Take two

minutes.

COMMISSIONER BORN:

--very small follow-up.

CHAIRMAN ANGELIDES:

No, take two minutes.

COMMISSIONER BORN:

I assume the requests for

novation were essentially an aspect of the run on Lehman

Brothers at that point?

WITNESS ZUBROW:

That would be correct.

COMMISSIONER BORN:

CHAIRMAN ANGELIDES:

COMMISSIONER BORN:

CHAIRMAN ANGELIDES:

COMMISSIONER MURREN:

Thank you.
That's it?
Yes, that's it.
Okay.

Ms. Murren.

Thank you, Mr. Chairman.

question for you, Mr. Zubrow, and it really follows down

this line of inquiry.

A lot of your testimony and also your commentary

has been very specific to Lehman Brothers.

wondering if you could provide us some context for that?

But I was

You have been around risk management for a long

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1

time through a number of different business cycles, and

could you talk a little bit about how you typically deal

with your clients in those situations where there may be

more uncertainty in the markets in the past?

And then also, specifically in this instance in

this crisis, other clients that you might have had to take

similar actions with with regard to collateral or reducing

your exposure, and whether in any way Lehman stood out as an

outlier in that regard or whether it was part of an overall

strategy that you had in dealing with the markets at the

time?

WITNESS ZUBROW:

Thank you, Commissioner, for

that question.

emphasize, one of the things that we were very focused on in

looking at all of our triparty repo clients, you know, was

the question of what was the character of their triparty

financing book.

Certainly as we talked about, but let me

And going back to the end of '07 and into the

spring of '08 following the Bear Stearns situation, we went

to all of our triparty clients and felt that the character

of their book had changed materially over the last period of

time.

The triparty business was originally a business

designed to help broker-dealers finance government and

agency inventories.

And we I think collectively woke up as

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1

an industry and found at the end of '07, beginning of '08,

that much of the financing, or a significant portion of the

financing that was being done by the broker-dealers had

shifted into less liquid, harder-to-value securities that

typically were not cleared through the Fed Wire or Fed

Systems, but rather cleared across DTC.

refer to those as DTC-eligible securities.

a characterization of typically being less liquid, obviously

less secure because they were not government or agency

And so we tended to
But they shared

bonds, and we were concerned that investors were not

providing the right credit analysis and view of that

collateral and applying the right haircuts in their

relationships with the broker-dealers.

During the spring and summer of '08, we worked

collaboratively with a number of the large broker-dealers,

large clearing, or large banks, as well as other investors

through the Counterparty Risk Management Policy Group to try

to articulate, among other things in that group, a series of

best practices for the triparty repo business.

We did that in a collaborative way.

articulated those best practices through that report, which

I believe you have a copy of.

in consultation with the New York Fed, recognizing that some

of the best practices that we were suggesting in that report

would have an impact on the financing of the broker-dealer

And we also did so very much

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1

community, the need for them to provide additional haircuts,

and ultimately to try to finance some of their inventory

investments through other types and means.

COMMISSIONER MURREN:

So then there were others

that you had made similar requests of, other than Lehman

Brothers, in that arrangement?

WITNESS ZUBROW:

We had discussions with all of

our triparty repo clients about the need to implement the

types of best practices that I talked about.

And in

particular, to move to making sure that during the intra-day

financing that JPMorgan Chase provided through the triparty

mechanism, that we move to a situation where we were

retaining at a minimum the full amount of the investor

haircut from the overnight financing arrangements.

But we also had discussions with each of our

clients about the need to move to more of a robust risk-

based haircut mechanism which would better take into account

the character of the securities that were being financed,

and in particular what the liqudation risks of those

securities were in the event of a dealer default.

COMMISSIONER MURREN:

Thank you.

On Lehman

specifically, could you talk a little bit about other areas

where you may have reduced your exposure to the firm?

24
25

WITNESS ZUBROW:

In fact, I think that throughout

the period of late August-September, we were actually

245
1

increasing our exposures to them by continuing to accept

novations from, you know, other counterparts, continuing to

trade with them on behalf of broker-dealers.

So as part of our efforts to continue to be

supportive of them in the marketplace, in addition to the

daily unwind that we were doing in the triparty repo book,

we were taking on additional exposures to them by accepting

these novations and doing this other trading activity.

COMMISSIONER MURREN:

And could you comment

briefly on the notion that there were participants in the

market that were engaged in manipulation of the markets?

And not just in Lehman Brothers, but also perhaps in the

securities of other financial firms?

Commissioner Hennessey's request that, if there is specific

information that you can share with this Commission, it

would be very helpful to try to ferret out the merit of some

of these allegations that have been made.

And I would echo

Because it has been made by many, many of the

witnesses that have come before us and we are curious to see

if we can pinpoint the merit and the validity of some of

these claims.

Is it your observation also that there was market

manipulation at work in the activities of some of these

securities of the financial companies, Bear Stearns, Lehman

Brothers, others?

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1

WITNESS ZUBROW:

I certainly have not made that

observation.

you look at the market spreads for Lehman Brothers during

this period of time, there is clearly a widening of their

credit spreads.

declining, but I don't have any speculation as to whether

there was any manipulation or other activities that were

going on such as you reference.

COMMISSIONER MURREN:

CHAIRMAN ANGELIDES:

impeccable.

What I would say is that it's clear that when

And obviously the price of their stock was

Thank you.
Your timing is always

Anyway, Mr. Wallison?

VICE CHAIRMAN THOMAS:

Mr. Chairman, prior to

turning it over, I would like to add five minutes to the

Commissioner's time, which doubles your time.

COMMISSIONER WALLISON:

That doesn't

quite do that, but--

VICE CHAIRMAN THOMAS:

COMMISSIONER WALLISON:

Thank you.

Five and five.
--in any event, I don't

know that I'll need it all.

CHAIRMAN ANGELIDES:

VICE CHAIRMAN THOMAS:

You take it all.

COMMISSIONER WALLISON:

I now have 13.

23
24
25

Take eight.

There we

are.
All right, I want to follow up in an area that we
haven't really discussed, either this morning or this

247
1

afternoon, and it's entirely possible that I am confused or

maybe not up-to-date, but my understanding of the discount

window would suggest to me that the discount window, at

least from what we've heard, should have been a useful

option for both Wachovia and for Lehman.

And I would like to understand a little bit about

why that was not true.

Now the discount window, as I have

always understood it, was for the purpose of allowing

financial institutions, banks--only banks, not bank holding

companies, as we were told this morning by the General

Counsel of the Fed--but banks, to address runs, withdrawals,

things of that kind, if they are solvent.

And the Fed would take good collateral and

monetize it, in effect, so that they could continue to meet

the obligations that they were facing when depositors were

taking their funds out because of panics, or fears, or

things like that.

In fact, the whole idea for establishing the

Federal Reserve was to overcome the problems that arise in

the case of runs.

Now let's start with Wachovia.

Wachovia, a bank

certainly, and I'll address this to you, Mr. Baxter, if I

can, why was the possibility of saving in effect Wachovia,

or at least making it able to deal with what we were told

was liquidity difficulties, not used, not actually

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1

available, or not a factor in the Wachovia case?

seems to have been looking for another bank to acquire them.

Everyone

Now that would only be true, it seems to me, if

Wachovia was in fact insolvent.

then the discount window was supposed to be the cure.

6
7

If it was simply illiquid,

Mr. Baxter, can you fill us in a little bit on
that, and then we will turn to the Lehman case?

WITNESS BAXTER:

Commissioner Wallison, I can't

speak about Wachovia, which is not located in the Second

Federal Reserve District, but in another Federal Reserve

District, so I am not familiar with the facts associated

with that.

13
14

I know Mr. Alvarez was here earlier.

I can speak

about--

COMMISSIONER WALLISON:

questions I didn't get to with Mr. Alvarez--

WITNESS BAXTER:

What was one of the

Some of the general philosophy

with respect to the discount window, you're quite correct

that under Section 10 of the Federal Reserve Act the

discount window is normally used for handling liquidity

problems in depository institutions, banks, roughly defined.

There are different programs under that section

of the Federal Reserve Act as a primary credit program for

banks that are in good shape.

credit program for banks that are in not such good

And then there's a secondary

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1

condition.

So there is a different type of lending done at

the discount window for institutions that are not as sound

as others.

It is intended principally for liquidity

problems.

It is not intended for a capital problem.

you're correct that where there is a capital deficiency in

an institution, often the supervisors, Fed included, will

look to other solutions to deal with those types of

problems, including mergers.

COMMISSIONER WALLISON:

And

So in the case of

Wachovia, you cannot speak directly to that, but there must

be some knowledge within the Federal Reserve about something

as significant as the Wachovia case, which we've spent so

much time on this morning.

Were you of the understanding that Wachovia was

insolvent at the time it was considered for some sort of

special takeover by Citi, and ultimately taken over by Wells

Fargo?

Were you of the view that it was insolvent?

WITNESS BAXTER:

of the Wachovia situation.

I don't have personal knowledge

COMMISSIONER WALLISON:

Okay.

I guess we will

try to address this question to the Chairman when he is

here.

24
25

That's a question I will save for him.
Now let me just turn to the Lehman case, because

it raises the same issues.

Lehman was eligible for the

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1

discount window, as I understand it.

clear, even from all the exchanges we've had, whether we are

talking only about LBI, the broker-dealer, or we are talking

about the holding company.

opened the discount window to the holding companies before

Lehman failed.

holding company, was eligible for discount window access.

8
9
10
11
12

And I cannot get

I thought that the Fed had

And in that case, Lehman, at least the

Is that your understanding?

Or am I wrong about

that?
WITNESS BAXTER:

That's not correct.

I'll try to

explain it, and I hope not to sound too much like a lawyer.
The discount window is used by lay people to

refer to lending programs of the Federal Reserve broadly.

The normal Federal Reserve lending program is the one under

Section 10(b) of the Federal Reserve Act to depository

institutions.

When we got into the credit crisis, and we got

into 2008, we started to think of using a statutory power

that had not been used since the Great Depression.

talking about Section 13, subdivision 3 of the Federal

Reserve Act which enables the Fed to lend to an individual,

a partnership, or a corporation, not a bank.

And I'm

And the first usage of that Section 13.3 power

occurred on March 11th of 2008 when we introduced the Term

Securities Lending Facility.

251
1

The second time we used that extraordinary power

was on March 14th when the Board of Governors authorized the

New York Fed to lend to Bear Stearns through JPMorgan Chase

to carry Bear Stearns through the weekend.

Now that's a special type--

COMMISSIONER WALLISON:

WITNESS BAXTER:

COMMISSIONER WALLISON:

WITNESS BAXTER:

Yes--

--of power used only-Right.

--in extraordinary and unusual

circumstances.

COMMISSIONER WALLISON:

But why would that power

not be of the same kind and purpose as the discount window

itself?

a broad phrase for the same kind of lending.

I mean, the use of the discount window term is just

The purpose of the discount window I described

before, the purpose of 13.3 was to make the same kind of

facilities available to nonbanks.

different rules?

other than simply to liquify institutions that are otherwise

solvent?

So does the Fed have

Is there some different purpose for 13.3

WITNESS BAXTER:

The statute is different in a

couple of significant respects.

language, for example, you will see in Section 13.3 that

that lending is to be done only when the lending Reserve

Bank finds that there is no adequate credit accommodations

252

If you look at the statutory

available to the putative borrower elsewhere.

Now that doesn't exist in Section 10(b).

banks can come to the window even though they can get credit

elsewhere.

Under Section 13.3, the--and I'm speaking as 13.3

before it was amended by Dodd-Frank--those institutions were

institutions that couldn't find credit elsewhere.

talking about extraordinary situations, borrowers who can't

get credit--

COMMISSIONER WALLISON:

So we're

But in Lehman--I'm sorry

to interrupt, but in Lehman we did have a firm that couldn't

get credit elsewhere.

when the whole idea is to provide liquidity to solvent

institutions?

So why was it excluded in under 13.3

WITNESS BAXTER:

This might be a long answer.

was not--Lehman's broker-dealer was not excluded under 13.3,

because it was eligible to borrow at the Term Securities

Lending Facility.

19
20
21

It was eligible--

COMMISSIONER WALLISON:
broker dealer.

I'm not talking about the

Can we focus only on the holding company?

WITNESS BAXTER:

With respect to the holding

company, a couple of things would need to happen.

need a new finding by the Board of Governors under Section

13.3 that authorized the Federal Reserve to lend to the

holding company.

We would

253
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That never happened.

promulgated by the Board.

That resolution was never

It was never promulgated by the

Board--

COMMISSIONER WALLISON:

for a--oh, yes, I'm sorry, for reasons that?

question.

WITNESS BAXTER:

Can I--may I interrupt
That's my

--for reasons that we were

getting into earlier today, that that would ahve been a

loan, a bridge to nowhere.

And I think Commissioner

Hennessey had a framing of that that was very elegant and

right.

face of a run.

plan that we were executing after Plan A fell apart and we

couldn't find a merger partner.

And we would have been lending to the parent in the
And it was inconsistent with the contingency

COMMISSIONER WALLISON:

Well the fact that you

had a different contingency plan can't be a factor.

important question has to be, if the institution is solvent-

-and Mr. Fuld has said it was solvent; and I haven't heard

anyone actually contradict that yet--if it was solvent, then

it doesn't matter what other plans you had in mind.

seems that the Board could have adopted a resolution that

made Lehman Brothers eligible for the use of 13.3--that is,

the parent company eligible for the use of 13.3.

24
25

The

Was it only the absence of a Board resolution
that stopped that from being accessible to Lehman Brothers,

254
1

the holding company?

WITNESS BAXTER:

No, Commissioner.

It was felt

that that kind of bridge loan was a bridge loan to nowhere,

because the management of Lehman had worked, I think as

diligently as possible, to find a solution to their problems

in the runup to Lehman weekend.

We had worked through Lehman weekend to find a

solution to those problems.

confidence in Lehman.

The market no longer had

The market was no longer willing to

trade with Lehman--

COMMISSIONER WALLISON:

again.

liquidity run, and that is the market has no confidence.

I'm sorry.

I'm going to interrupt

But that is a characteristic of a

The purpose of the Fed liquifying or monetizing

the assets of a company that otherwise has unsaleable or

assets for which there isn't a liquid market, the purpose of

that is to say to the market:

We are going to lend as much as it needs in order to

maintain its ability to meet its obligations, because

otherwise it is solvent.

discount window.

this is a solvent company.

That is the purpose of the

You're sending a signal.

And eventually, the run

stops because people say, well, the Fed has concluded that

this is a solvent company; there's nothing for me to worry

about; there's plenty of money to meet my obligations.

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Now I don't quite understand yet why the Fed

didn't make this--didn't come to this decision and allow

Lehman Brothers to use that facility.

WITNESS BAXTER:

COMMISSIONER WALLISON:

We saw no end to the run.
If they're solvent, if

they're solvent then there is always an end to the run.

WITNESS BAXTER:

Commissioner Wallison, one

definition of "insolvent" is failure to pay your debts as

they come due.

And that was the situation that Lehman was

experiencing at the end of Lehman week.

its debts as they come due.

it.

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No one would extend credit to

COMMISSIONER WALLISON:

CHAIRMAN ANGELIDES:

Well, let's do this, because

I think he accorded five more minutes-COMMISSIONER WALLISON:

CHAIRMAN ANGELIDES:

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May I have a few more

minutes?

And it couldn't pay

I already got five.

Let's go to Mr. Thompson and

then swing back.
VICE CHAIRMAN THOMAS:

I should have given you

two, and then two, and then you've have felt really good.

(Laughter.)

CHAIRMAN ANGELIDES:

Let's do this.

It's a good

line of questioning, but I would like to accord Mr. Thompson

the opportunity, and then maybe we can round back up.

All

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right?

COMMISSIONER WALLISON:

Sure.

COMMISSIONER THOMPSON:

Thank you, Mr. Chairman.

And, gentlemen, thank you for being with us.

Good.

Thank you.

Mr. Fuld, there's been much said about the

mistakes that you made, or the firm made.

conversation about the risk management techniques or

practices at JPMorgan Chase.

There's been

Obviously those practices weren't the same, or

the systems weren't the same, at Lehman Brothers.

talk a bit about the risk management practices at Lehman

Brothers, and why you didn't see this coming?

WITNESS FULD:

Can you

Lehman very much prided itself in

a strong risk management culture.

the firm.

committee.

That's how I grew up in

The executive committee was in fact the risk

A number of my senior executives had a majority

of their net worth tied up in Lehman Brothers.

going to say 100 percent of our employees, but a huge

percent owned stock in the firm.

had 28,000 risk managers.

I'm not

So I looked at it that we

Our risk management philosophy was no surprises.

Never get yourself on the end of a limb where you can't come

back.

you have an exit strategy.

Do not rely on risk modeling.

And always make sure

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We had executive committee meetings, formal ones,

every single Monday.

always risk and risk management.

officers, were at those executive committee meetings.

The number one piece on the agenda was
Our risk, senior risk

We had presentations to the board about risk and

risk management.

risk and risk management.

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We had presentations to the agencies about

COMMISSIONER THOMPSON:
Something obviously didn't work.
trying to get at.

But what failed?
And so that's what I'm

What failed?

WITNESS FULD:

What failed in the beginning I

believe was rectified in the end.

beginning was the sense that the dislocations and

disruptions in the mortgage markets mostly around

residentials was in fact contained.

one that had that view.

But what failed in the

And we weren't the only

That contageon spread to other asset classes.

believe that we reacted, not because there were one or two

people floating around the firm; it was because the risk

management committee said other asset classes are being

affected, and that is what drove that reduction in less

liquid assets.

That was our focus.

It was not about bringing down governments.

was not about bringing down corporates, or on-the-run

equities.

It was where are we vulnerable?

Where can we be

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most affected in the P&L which will eventually then hurt our

capital?

That was around less liquid assets, commercial

real estate, residential mortgages, leveraged loans.

are the things we focused on.

almost 50 percent.

Those

That's what we brought down

Did it fail in the beginning?

Let's just say

that we had--we made poor judgments as far as timing on

building some of those businesses.

We had poor judgments

and timing on making some investments.

mistakes, addressed those mistakes, and as I said I believe in both

We made those

my written and oral, by the time we got to the third quarter we

were in a solid position.

Did I answer that?

COMMISSIONER THOMPSON:

Yes.

So, Mr. Miller, you

were the one who said, if Lehman is allowed to fail it would

be financial armageddon.

to the counterparties in many of those transactions and how

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Can you talk about what's happened

that armageddon has manifested itself post-Lehman?
WITNESS MILLER:

Yes, Commissioner.

There, as

Mr. Fuld has pointed out, there are many different classes

of assets, and businesses that Lehman operated.

In connection with the derivatives, that's largely

outside the sphere of the bankruptcy proceeding, except for

the contracts that are still open.

enormous amount of time.

And that's consuming an

Lehman suffered tremendous losses in derivatives

because the counterparties took advantage of the contracts,

closed out those contracts, liquidated the collateral in a

failing market, so they have some very substantial claims

against the Estate.

There were many commercial real estate loan

transactions, and real estate loan transactions where Lehman

was a member of the syndicate, or the lead lender, and was

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not able to fulfill its obligations in terms of financing.

And those entities, many of them, ended up in a bankruptcy

proceeding.

Overseas, many of the Lehman Global offices, as I

said, have now been subjected to insolvency proceedings.

those cases there were notes sold individually in those

countries.

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There are huge claims in that connection.
I think I pointed out there are 66,000 claims

that have been filed against Lehman.

In a gross amount,

$830 billion.

that are unliquidated because they haven't been able to

calculate the damages.

There are many claims that are on file today

Those are the direct results of the bankruptcy.

I think there are a lot of incidental results of the

bankruptcy that nobody may have contemplated.

In the week that followed September 15, on I

think it was Wednesday, Chicago Mercantile Exchange closed

out all the Lehman accounts.

Lehman of approximately $1.4 billion.

positions were auctioned off at very reduced values.

That resulted in a loss to
All of Lehman's

The commercial paper market froze up on

Wednesday.

redeem, or they thought they would be unable to redeem

commercial paper or sell commercial paper, and there were

questions raised as to their ability to meet their

And major U.S. corporations were unable to

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obligations.

Banks were concerned about backup lines on

commercial paper.

failures.

What you had is almost a whirlpool of

What was created was a crisis of confidence.
You have to remember that prior to Lehman's

failure there was a growing expectation that, no matter what

happened, somebody would intervene and save the situation.

And I think that was accentuated by the Bear Stearns

situation.

And many people in the market just assumed, and

in the public, that if there was a crisis of some kind there

would be some intervention.

And remember, in all of those situations, and

going even back to what Mr. Baxter referred to as long-term

capital management, no creditor was hurt, and creditors were

always paid.

So while there was, yes, a contraction of credit,

most everybody, at least in my world, thought that there

would be some bailout of some kind.

COMMISSIONER THOMPSON:

So in your opinion there

could have been actions taken that could have mitigated the

aftermath of the Lehman collapse, or even--

WITNESS MILLER:

I believe so.

And I understand

Mr. Baxter's position, but as Mr. Fuld points out there were

assets there.

orderly wind-down with those assets serving to back up, let

Even if this was a bridge to nowhere, just an

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me call it the unlimited guaranty of the Fed, over an

orderly period of time the values that were inherent in the

balance sheet were there.

What happened to them, they were basically

liquidated at distressed prices.

value which, putting aside the ancillary effects of the

bankruptcy, that could have been recaptured with an orderly

wind-down.

COMMISSIONER THOMPSON:

WITNESS MILLER:

So you lost all of that

Sure--

Now I look at it, you know, when

somebody comes into the emergency room and is on the

operating table and hemorrhaging, you don't ask "can you pay

the surgeon?"

You save the patient.

I look at Lehman as being a patient.

And if

there was a calculation that the systemic risks were so

great, somebody had an innovative way of avoiding those

systemic differences.

automobile industry.

industry.

Somebody found a say in the
They could have found a way in this

COMMISSIONER THOMPSON:

Mr. Zubrow, can you talk

about the consequences for others in the industry who

weren't counterparties to Lehman?

WITNESS ZUBROW:

I mean, what happened?

Well I think Mr. Miller has

summarized a lot of the other knockon effects post the

Lehman bankruptcy.

Certainly, you know, there continued to

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be concerns in the marketplace over the creditworthiness of

other broker-dealers.

Mr. Baxter has talked about the other

extraordinary efforts that the New York Fed and the Fed took

with respect to other enterprises, but I would just say that

as a general matter in the marketplace following the

bankruptcy of Lehman, there continued to be a contraction of

credit availability and a concern about lending to many

financial institutions.

COMMISSIONER THOMPSON:

So, Mr. Fuld, your view

would be that Lehman was too big to fail and somebody

screwed up?

WITNESS FULD:

thought about the too big to fail.

mistake that was made was that Lehman as a sound company was

mandated to file for bankruptcy.

mistake.

I never really--I never really
In retrospect, the big

That was the first

The second mistake was the fact that it was

forced to file for bankruptcy, and the knockon effect not

only in this country but also throughout the world, that was

the second mistake.

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COMMISSIONER THOMPSON:

Thank you very much,

Mr. Chairman.
CHAIRMAN ANGELIDES:

All right, a couple of

quick, just very quick questions I had on the remaining part

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of my time, just very quickly.
Mr. Zubrow, as I said I entered into the record a

chronology earlier on about the interrelationship between

JPMorgan Chase and Lehman Brothers.

One of the things we didn't have a chance to talk

about today is the relationship, extensively, even though

some members did, between counterparties is quite

fascinating to see how many counterparties actually did

stick around; how many did believe Lehman would be saved.

Your relationship was a very special one because

of the triparty repo.

very quick questions.

And I just wanted to ask you just two

On September 9th you demanded $5 billion in

collateral, and I believe over the next couple of days about

$3.6 billion was posted.

Correct?

WITNESS ZUBROW:

That's correct.

CHAIRMAN ANGELIDES:

And then again on September

11--by the way, this is after a series of amendments to the

existing agreements--on September 11th, you demanded another

$5 billion, and made it clear that if you didn't receive the

$5 billion we intend to exercise our right to decline to

extend credit to you under the Clearance Agreement, which

means essentially the next day Lehman couldn't operate.

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Is that true?

That basically you said post the

$5 billion or we're not going to provide inter-day credit?

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WITNESS ZUBROW:

On September 11th, we asked for

$5 billion of cash collateral.

that we had done in light of the changing market conditions

of collateral that they had previously posted to us.

That followed an analysis

As I said in my testimony, much of the collateral

that was previously posted to us was very much dependent

upon the Lehman credit itself, as well as certain structured

transactions.

We did not think that that collateral had the

value that Lehman ascribed to it, and we, on the September

11th collateral call, you know, asked, and Lehman agreed,

for cash collateral.

Following that agreement with Lehman, we did send

them a notice that you referenced, but it was following

their agreement that they had already told us that they

would post the cash collateral, and we had every expectation

that they would.

CHAIRMAN ANGELIDES:

One more question on this.

And that is, that according to our interview with Mr. Fuld,

he approved the posting of the $5 billion after Mr. Black

said that Lehman would get it back the next day.

interrogatories and received them back from Mr. Black.

We're in the process of, we've sent them to Mr. Dimon.

is a matter we haven't had a lot of time to talk about

today, but we continue to look at.

We sent

This

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Was it your recollection that there was a promise
to return the collateral?

WITNESS ZUBROW:

there was no such promise.

No.

CHAIRMAN ANGELIDES:

It is my recollection that

All right.

Mr. Fuld, very

quickly, to what extent was this $8.6 billion draw on your

liquidity a death blow?

WITNESS FULD:

I was really only aware of the

Thursday conversation on the--

CHAIRMAN ANGELIDES:

WITNESS FULD:

Meaning the 11th.

On the 11th, that I participated

in.

I believe the call was already going.

was, Ian Lowitt, Paolo Tonucci, asked me to participate.

believe Jamie Dimon, Steve Black, were on that call.

CHAIRMAN ANGELIDES:

WITNESS FULD:

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I forget who it
I

And Mr. Zubrow.

In all fairness, I was not aware

that Mr. Zubrow was part of that call then, but whatever.
They asked for the $5 billion.

He nodded his head.

inter-day, I assume I get this back tomorrow.

recollection very clearly is that they said, yes.

I said, fine.

I looked at Ian.

CHAIRMAN ANGELIDES:

I said, but as in all

All right.

Do you remember

Mr. Tonucci saying, during this conversation, when Tonucci

asked why JPMorgan wanted the collateral a participant,

perhaps Dimon responded "no reason."

When Tonucci further

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asked, "What is to keep you from asking for $10 billion

tomorrow?", that participant, who may have been Mr. Dimon,

according to these notes, said nothing, maybe we will.

I guess my question is:

these calls at the end to your liquidity run?

and were they the trigger point?

yes or no?

adverse events happening during those days?

How fundamental were
Were they--

Were they the death knell,

Or was this just one of many of a series of

WITNESS FULD:

The clearing banks ended up with

$16 to $17 billion of additional collateral out of the

thirty of liquidity that we lost in those three days.

we had that collateral, I think that would have made a huge

difference.

CHAIRMAN ANGELIDES:

All right.

Had

The only other

comment I want to make, and see if other members have wrap-

up questions here, is, I just have a context comment today,

which really is about our two panels today.

One of the things that strikes me is we've heard

about Wachovia which suffered a run when WaMu wasn't saved.

And today we focused on Lehman that wasn't saved, and the

consequences of that.

mindful that, while we spent our day on the exception, it's

the exception that proves the rule:

massive and extensive bailouts.

And I think all of us are very

that this was an era of

And I just wanted to make that comment, because

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we focused on these two instances where there was the

aberration, and what apparently became a sweeping policy.

At a certain level, that old adage got turned on its head

and it became:

fail, fail again.

era.

If at first you don't succeed, then fail,
And it became kind of the motto of that

And I just wanted to put today's hearing in context.
Let's do this.

Additional comments.

I think Peter Wallison, maybe one question each.

did you have a question?

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want to wrap up.

Byron, and
And, Doug,

And then the Vice Chairman may

One question each, so we can proceed--I

COMMISSIONER GEORGIOU:

I just wanted to comment

on your comment, Mr. Fuld, about you had a sound institution

that basically was compelled to file bankruptcy.

And I guess that really goes to the fundamental,

one of the fundamental questions we're here to answer is

whether, you know, these were extraordinary events that

occurred kind of out of nowhere that put a whole bunch of

sound institutions into a position where their liquidity was

inadequate to meet their normal obligations.

failures, certain failures, and other institutions required

liquidity to prop them up until circumstances developed?

Or, was there certain fundamental unsoundness

And there were

within the institutions which is what led your creditors to

make greater demands and insist upon greater collateral and

require greater haircuts on the triparty repos and the

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short-term financing?

I mean, I guess it's more of a comment, I

suppose, than a question.

day, one of the major things we have to resolve, is whether

these were just a bunch of sound institutions who faced the

stress of an economic crisis, or a financial crisis that was

shortlived, or really were embedded within those

institutions many, many unsound assets which have to find

themselves deleveraged out of the system in order to get

That really is, at the end of the

back to more fundamentally sound institutions.

So I understand from your perspective you

regarded your institution as sound.

I respect that.

You

devoted your life to it, your career to it, and you would

have that perspective regardless.

free from doubt because, as Mr. Zubrow said, one of the

definitions of insolvency is the inability to meet your

obligations when they come due, and you couldn't do that,

given the circumstances.

WITNESS FULD:

But it's not entirely

Is that a statement?

Or is that--

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COMMISSIONER GEORGIOU:

CHAIRMAN ANGELIDES:

VICE CHAIRMAN THOMAS:

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It's a statement, and--

I think it was a statement.
I think it was a

statement.
COMMISSIONER GEORGIOU:

It's really a statement.

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CHAIRMAN ANGELIDES:

WITNESS FULD:

CHAIRMAN ANGELIDES:

COMMISSIONER GEORGIOU:

CHAIRMAN ANGELIDES:

All right, Mr. Wallison--

May I give an answer, though?
A quick one, yes, sir.
A quick one, sure.

Quick, concise, right to the

point.

WITNESS FULD:

You know me well by this point.

VICE CHAIRMAN THOMAS:

WITNESS FULD:

Thank you.

All I can say is, right after us

came two other investment banks.

addressed with some form of support, they would have gone.

COMMISSIONER GEORGIOU:

Had they not been

But that doesn't answer

the question, because there may have been unsoundness within

those institutions as well.

what our charge is, is to identify whether there were

causal--whether there were causes that swept across the

range of institutions that found themselves in jeopardy

during this period that we could avoid on a go-forward basis

to avoid that kind of circumstance occurring again.

rather than it being sort of a God-created flood that

threatened to sweep over all these institutions, you know,

you could say that there were human-created problems within

the institutions as well.

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And I suspect that is part of

CHAIRMAN ANGELIDES:
age as Chair--

That,

I'm getting soft in my old

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VICE CHAIRMAN THOMAS:

I'll buck you up, let's

go.
CHAIRMAN ANGELIDES:

Okay, very quickly.

Mr.

Wallison, one question, then Mr. Vice Chairman for closing

remark, and then we will adjourn.

COMMISSIONER WALLISON:

One question.

And this

is for Mr. Fuld, and I don't want to put words in Mr.

Baxter's mouth, but I took away from our discussion that if

the Fed had adopted the appropriate resolution under 13.3

that would have allowed them to take your illiquid assets

and monetize them, as they might do with a solvent bank, if

that had occurred would Lehman have been able to survive?

WITNESS FULD:

I believe so.

COMMISSIONER WALLISON:

CHAIRMAN ANGELIDES:

VICE CHAIRMAN THOMAS:

Thank you.

Mr. Vice Chairman.
Mr. Baxter, on the 13.3

decision, was that a discretionary decision on the part of

the Federal Reserve?

WITNESS BAXTER:

The decision by the Board?

VICE CHAIRMAN THOMAS:

WITNESS BAXTER:

VICE CHAIRMAN THOMAS:

Yes.

Yes.
Well, I mean when you have

a discretionary decision, you look at the consequences of

the decision and you basically focus on 'what if?'

if you go ahead and make that decision, what have you done

So that

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and what are the consequences following that?
So if there's a required, or an automatic

discount window for banks where the law says you have to do

it, then I understand there's no discretion.

discretion, you have to weigh the facts as you know them in

terms of making that decision.

Did Heather want to intervene?

Where there's

No?

I just have

to tell you folk, it's interesting what we're going to be

doing for the next couple of weeks.

Basically what I've heard here is

wudda/cudda/shudda, you know, if ifs and buts were candy and

nuts we'd all have a merry Christmas.

billions of dollars.

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We're talking about

Hundreds of billions of dollars.

If I'd of just had another $70 billion, we might
of been able to make it another week.
We're going to go out and we're going to listen

to people who are not in need of billions, or hundreds of

billions, they just need a few thousand.

foreclosure.

on restructuring a loan, a bridge, to save their houses.

They're facing

They're facing the inability to get assistance

And if any of them are still watching after

they've listened to these discussions about gee, another $50

billion here, another $100 billion there and we might have

been able to hang on, and they're sitting there saying:

What world are these people in?

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If you took the hundreds of billions and allowed

us as we go out to the communities across America, listening

to people say "I could have made it.

restructuring.

out we were in foreclosure, I asked them why didn't they get

back to me?"

They told me they were

I never got the call back.

And when I found

I've heard that over, and over again.

So as you have your arguments about which hundred

billion was needed when, you've really got to get out there

and take a look, or at least listen, or maybe watch what

we're going to be hearing from people who just don't get it.

When do they get a bridge to somewhere?

modification on the loan?

When do they get a

And it isn't the extreme example of a guy who

runs a taco truck who got a loan and was living in a

$450,000 home for a month.

there.

homes, who are making real payments, and needed a little

bridge.

billion dollar bridge.

$25,000 bridge.

That's not the problem out

It's real people, who have real jobs, who had real

Not a trillion dollar bridge.

Not a hundred

Not even a billion dollar bridge.

A $15,000 bridge.

And we're going to go listen to them.

Finally,

we're leaving Washington.

Street and we're going to go talk to some people who would

like to have their say about what has and hasn't happened.

And I just wish I could have you all along so that you could

We're leaving New York and Wall

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appreciate and understand why this coming election in

November is under a whole lot more turmoil than anyone

thought it was going to be.

So thank you very much for your testimony.

Our

job is to try to understand and explain what happened.

some of it is learning what didn't happen.

there's arguments about what happened, but I think there are

a whole lot more arguments about what didn't happen.

And

And obviously

Thank you, Mr. Chairman.

CHAIRMAN ANGELIDES:

(No response.)

CHAIRMAN ANGELIDES:

Members?

Anything more?

I want to thank the panel

members for coming here today, for your written testimony.

And as the Vice Chair says, we probably will be following up

with you, as we are, as I mentioned, with JPMorgan on some

issues.

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And I want to thank you all very, very much.
Thank you.

We will recommence here at 9:00 a.m.

tomorrow morning with Chairman Bernanke.
(Whereupon, at 3:42 p.m., Wednesday, September 1,

2010, the meeting was recessed, to reconvene at 9:00 a.m.,

Thursday, September 2, 2010.)

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FRASER