Full text of Financial Crisis Inquiry Commission : Documents Relating to the Financial Crisis of 2007-2009 : Transcript of Financial Crisis Inquiry Commission Closed Session With Ben Bernanke, Chairman of the Federal Reserve, November 17, 2009

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United States of America

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

*** Confidential ***

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--o0o--

CHAIR ANGELIDES:
MR. BERNANKE:

Welcome, Mr. Chairman.

Nice to be here.

CHAIR ANGELIDES:

Thank you.

Good.

So thank you for joining us today.

And as we

spoke, as you know, we are underway with our work now.
And we wanted to ask you to come by today to give us
your perspectives on the crisis, the causes.

And I

thought what we’d do is, per our discussion, perhaps you
would make some opening remarks of whatever is
comfortable, 15, 20 minutes; and then we spend the
balance of the time asking questions.
MR. BERNANKE:

Sounds great.

CHAIR ANGELIDES:

And I should add, before you

start, that we are recording this for the archives for
our work.
MR. BERNANKE:

Good.

Thank you.

Thank you for again giving me this
opportunity.

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I’m sure you will hear so many of the common
themes, so I thought I would just focus on some areas
which I might have slightly different perspectives than
some others.

So let me just go through a few areas.

One general area you’re going to want to look
at is the macroeconomic context, the macroeconomic
background that led to the risk-taking and so on of the
crisis.
So let me just identify some hypotheses which
you’ll want to look into.
So why did risk-taking increase?
One hypothesis is the so-called great
moderation.

In a way, this suggests that monetary and

fiscal policy were too successful during the eighties
and nineties in creating a very stable environment, low
inflation.

And that it was that sense of excessive

security that led to risk-taking.

That’s one

hypothesis.
A second hypothesis, which I have advocated in
a number of speeches, which has been greatly expanded
and worked by Martin Wolf, the journalist, and others,

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is what’s called the global savings glut.

And the idea

here basically is that after the Asian crisis in the
nineties, many developing emerging-market economies
became capital exporters rather than capital importers.
That was because either they had large savings and
investment differentials, as in China, for example; or
they had lots of revenue from commodities, like the oil
producers; or they were acquiring large amounts of
foreign exchange reserves, which was a lesson of the
nineties, that that was supposedly a way to protect
themselves against the exchange-rate problems.

All

those things created large capital inflows into the
Western industrial countries, notably the United States.
It’s a common observation in the context of
emerging-market financial crises that they’re often
preceded by large capital inflows from abroad and that
the problem is that the local banking system can’t
handle the massive inflow of capital.

So by analogy,

sort of a similar story may have happened in the United
States.
A particular feature of that is that what may

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have mattered under this story is not just the net
inflows, but the gross inflows.

People like Ricardo

Caballero of MIT, have argued that the emerging markets
were looking for high-quality, safe assets, like
Treasuries, for example.

So there were huge amounts of

inflows that were only partly offset by U.S. investment
abroad.

And that, indeed, once there became a sort of

shortage of Treasuries, that there was strong incentives
to U.S. financial institutions to create, quote, “safe
assets.”

And that’s where the securitized AAA credit

assets came from.
By the way, the savings glut idea doesn’t
necessarily mean that there was a lot of extra saving,
per se, but, rather, that savings and investment were
out of balance.

So part of the reason for the savings

glut was -- by this story -- was that investment in the
emerging markets dropped after the crisis, and that was
part of the reason for the imbalance.
The third explanation, which I’m sure you’ll
investigate, has to do with monetary policy in 2003,
2004, 2005.

Interest rates were down to 1 percent

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during that period for reasons having to do with both
the slow recovery from the recession and because of
concerns about deflation at that time.

Some have

argued -- and I’m sure you’ll look at it -- that those
low rates contributed to the risk-taking.
We are working on a staff paper that goes into
this in some detail, which will be ready by the end of
the year.

And I’m going to give a speech on this topic

around New Year’s.

So we will try to provide you with

some information on this general topic to give you our
perspective.
I think there are a lot of different
components of this issue - if I could just sort of
illustrate why there are a number of different questions
to be looked at.
The first question is, was, in fact, this
policy the cause or a major cause?

And as I said, there

are some alternative hypotheses, like the savings glut
and some other things.
A second question is, if it was a cause, you
know, was it a knowable problem?

Was the Fed doing the

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best it could given the information it had, or was it
neglecting information it should have used?

And that’s

a second question.
And related to that is the general issue,
which has become very hot in monetary policy circles,
which is, should monetary policy be used to try to knock
down bubbles or not?
Just for the record, my view is that it can be
a backup, but that the first line of defense ought to be
supervision/regulation.
And then I guess the last point I would make
about this -- and, again, this will be explored in more
detail in our paper -- is the following:

Even if you

believe that the Fed’s monetary policy was a contributor
to the bubbles, it should be noted that even the people
who are most critical of the Fed’s policy acknowledged
that it was only -- it was not a large mistake.

It was

a percentage point or two relative to, say, what the
Taylor rule, which is the standard measure of interest
rate policy is.
And so then the question is, you know, how can

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you have -- if you have a situation where a relatively
small mistake -- if it was a mistake, I’m just accepting
that hypothesis -- leads to the biggest financial crisis
since World War II, I mean, what does that say?

They

say that the system itself was inherently unstable and
that a relatively small shock was enough to knock it off
the pedestal.
So I guess my own view is that if the system
had been adequately stable, had strong enough
supervision, et cetera, et cetera, it could have dealt
with this problem or other problems without collapsing.
So that’s the general topic of macroeconomic context,
which I’m sure you’ll want to look at.
A second area, I’ll call the “shadow banking
system.”

I’m sure you’ll look in detail at housing

finance, at the GSEs, at subprime mortgages.

So you

don’t need me to go through that, other than to note
that the Fed is one for two on those.

The Fed was

concerned about the GSEs and their capitalization and
their financing for a long time.

Chairman Greenspan

testified about that way back in -- you know, 15 years.

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So we were right on that one.
But, you know, we’ve acknowledged that we
didn’t do enough to prevent the subprime lending crisis,
in particular, since we had the authority to put some
rules against some of the practices that occurred.
What I’d like to call your attention to is the
broader phenomenon of the so-called shadow banking
system, which subprime mortgages were only one type of
asset which were bundled together into securities, and
then these securities were then sold through various
legal off-balance-sheet type mechanisms to investors,
usually with AAA ratings from the credit-rating
agencies.
Among other things, a striking aspect of these
securitizations is that these vehicles, these
special-purpose vehicles, et cetera, typically held
long-term assets, like mortgages, but were financed by
very short-term, overnight type money, commercial paper,
et cetera.
this.

And there’s some interesting analysis to

One example is some work by Gary Gorton,

G-O-R-T-O-N, at Penn.

He might be at Yale now.

I’m

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sorry.
CHAIR ANGELIDES:
MR. BERNANKE:

Yale.

He was at Penn before.

And he points out that it’s like an
old-fashioned bank before deposit insurance, that the
depositors in that bank, as long as they think the bank
is 100 percent safe, they’ll leave the money in.

But as

soon as they get some loss of confidence, they’re going
to pull their money out.

When the subprime mortgages

began to go bad, a number of us, like myself and
Paulson, were wrong in saying that this was a contained
problem.

And the reason we were wrong was that subprime

mortgages themselves are a pretty small asset class.
You know, the stock market goes up and down every day
more than the entire value of the subprime mortgages in
the country.

But what created the contagion, or one of

the things that created the contagion, was that the
subprime mortgages were entangled in these huge
securitized pools, so they started to take losses and in
some cases, the credit-rating agencies, which had done a
bad job basically of rating them began to downgrade

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them.

And once there was fear that these securitized

credit instruments were not perfectly safe, then it was
just like an old-fashioned bank run.

And the commercial

paper market began to pull their money out.

That

created huge problems for the financing of these things.
It forced the banks to take them back on their balance
sheets or to support them and so on.

So there was an

old-fashioned bank run, which I think is a really
interesting factor.
Of course, again, flaws in the securitization
process.

I’m sure you’ll want to look at the

credit-rating agencies.
did wrong.

There were a lot of things they

There were issues of conflict of interest.

There’s issues of whether they used the right models.
Clearly, they did not.

They did not take into account

the appropriate correlation between -- across the
categories of mortgages and so on.
A third category of topics has to do with
regulation.

Regulatory structure, which I will

distinguish from supervision in a moment.
There were a number of aspects here, which I

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won’t go into in any detail.

One -- they mentioned

three subheads.
One is gaps in coverage.
example.

AIG is a great

AIG was overseen by the Office of Thrift

Supervision because they held a little thrift, and there
was nobody really looking at that company and the risks
they were taking.
Another example is the investment banks, which
were a huge problem, of course, Bear and Lehman and
Merrill, et cetera.

They were not officially, legally

supervised by anybody.

Only through a voluntary

arrangement with the SEC did they become under the SEC’s
oversight, but the SEC is not an examination agency;
they’re an enforcement agency.

They did not really

examine those firms in the way banking agencies did.
So gaps is number one.
Number two, I would mention capital and
liquidity.

You know, was the Basel framework adequate?

I’m sure you’ll look at that.
I think one of the things that struck me the
most about this, though, was liquidity which, again, we

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saw in the crisis in September and October.

We saw what

are, again, old-fashioned bank runs, except they were
much more sophisticated.

For example, runs in the

tri-party repo market, where what we used to think was
very stable funding, which is funding through repurchase
agreements where the investment banks would put out
assets overnight and use that as collateral, they
thought that was a pretty much foolproof form of
short-term funding.

But in a crisis where people began

to doubt the liquidity or the value of those assets, the
haircuts went up and you got into a vicious cycle which
led to the Bear Stearns collapse and was important in
the Lehman collapse as well.
There’s been some interesting work on this.
There’s Markus Brunnermeier at Princeton, along with
Charles Goodhart and others have written some nice
papers on this.

Gorton, again, has shown some good

papers on this.

But, again, liquidity issues were just

as important as capital issues, I think, in the fall
last year.
And finally, under the heading of regulation,

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“too big to fail,” you’re going to look at that, I’m
sure, in great deal.
so big?

You know, why did the firms become

Why did they become so interconnected?
From my own experience, trying to deal with

the crisis, by far the worst problem was the lack of an
appropriate framework for dealing with failing non-bank
firms.

So we have an FDIC framework for dealing with

failing banks, but the general public does not clearly
distinguish between banks and bank holding companies,
but they are very different institutions legally and
structurally.
We do not have tools for dealing with bank
holding companies.

So the ad hoc responses to Lehman

and AIG, et cetera, were essentially forced, I would
argue, by the lack of appropriate tools.
A couple of other things.

If you looked at

the weaknesses in financial management, if you look at
the private sector for a moment, there were a lot of
problems.

But I think a very important area was

weakness of risk management.

So these firms became very

big and they became very complicated.

They got involved

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in many activities.

And they simply did not -- and, of

course, the supervisors bear some responsibility for not
insisting appropriately that they do it -- but they did
not have, and some of them still don’t have to our
satisfaction, the management information systems, the
techniques, and so on, in order to look at their risks
across their entire business.

Not just in each

individual subsidiary, but across the entire firm.
So liquidity was an issue there, measuring
liquidity.

But, you know, one of the -- I’ll just give

you one example, which is that there was a view -- and
some people at this table have spoken against this view
correctly -- that the derivatives and so on were going
to create much more risk-sharing, you know, spreading
risks out, so that even though there were a lot of risks
in the system, they would be held by lots of different
investors.
It turned out that, in many cases, large
institutions were exposed to risks in very concentrated
ways that they did not even appreciate, they didn’t even
understand.

So one part of their business would be

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holding subprime mortgages, another would be exposed to
another company that was vulnerable to subprime
mortgages.

A third would have exposures to a SIV which

held subprime mortgages, et cetera, et cetera.

And they

had no way of abrogating all of that.
Supervision, two comments:

One is, we had –-

under Graham-Leach-Bliley, we had consolidated
supervision, and the Fed is the umbrella supervisor of
bank holding companies and financial holding companies.
The Graham-Leach-Bliley law, however, was ambiguous in
that it was not clear to what extent the Fed could
override or even be involved in the supervision of the
subsidiary companies which were, according to the law,
primary supervisors were the functional regulators, like
the SEC or the OCC.

So there was a certain amount of

uncertainty about to what extent the Fed should be
looking at non-bank subs, et cetera.
We have since, in the last year or two, become
much more aggressive in doing that; but that was clearly
a problem with the law.
Another aspect of supervision is the lack of

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what has become known as “macroprudential” or “systemic”
supervision.
firms.

There was too much focus on individual

Sort of a typical thing would be, you know, this

firm owns subprime mortgages, they’ve now gotten rid of
them, so we’re fine.

But nobody asked the question:

Where did they go and how did it affect the system?

And

we saw in the crisis lots of systemic risks that arose
because of weaknesses in the infrastructure of the
system, interactions between firms, contagion, and so
on, which weren’t looked at adequately.
The Fed is currently revamping its supervision
to take into account more macroprudential types of
oversight.
And the last comment -- and with Ms. Born
here and others that I don’t need to go into in much
detail -- but obviously OTC derivatives were a problem.
They may not have been a causal problem, but they
transmitted stocks.

There were problems with the

clearing of settlement of OTC derivatives.

And there

were problems with the risk management, AIG being the
poster child example of that.

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And, of course, the Administration’s proposal
and proposals from other bodies have tried to increase
the use of central counterparties and other mechanisms
to make the derivatives a safer instrument.
That’s a very quick overview of some of the
themes that I would just put before you.

And I know

you’ve got a lot of others to think about.
Vice Chairman Thomas:
list in any particular way?

Should we look at this

Is it hierarchical, is it

ranking, or is it just -MR. BERNANKE:

No, just an intent to list the

major themes that I think you ought to put in your
hopper.
Vice Chairman Thomas:

So do we want go

through, and do 1, 2, 3, 4, 5?
MR. BERNANKE:

Well, I don’t see how you can

avoid -Vice Chairman Thomas:

There isn’t a

consistency in terms of what you’re looking at?
MR. BERNANKE:

Yes, looking at the

macroprudential part.

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Vice Chairman Thomas:
MR. BERNANKE:

Right.

I think the issue of the shadow

banking system is very important and the role of the
maturity transformation, the fact of the use of the
short-term financing is something that focus on, say,
subprime lending might miss, and I think you need to
think about that.

And I think that really was a very

important element in the crisis, as was liquidity
problems associated with -- you know, with Lehman and
Bear Stearns and so on.

So those are some things you

might otherwise perhaps miss.
I think you’ll obviously have to look at both
the risk management in the private sector and the
supervision regulation of the government regulators.

So

I don’t think -- I’m sure you’ll have to look at those
things as well.

But I wanted to point out a few things

from a perspective that you may or may not have
otherwise looked at.
CHAIR ANGELIDES:

All right, I think what we’d

like to do is go around and pose questions to you for
the time you’re here.

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MR. BERNANKE:

Okay, great.

CHAIR ANGELIDES:

Peter, why don’t we start

with you?
COMMISSIONER WALLISON:

Okay, I’m interested

in what happened with Bear Stearns, Lehman, and AIG, and
your perspective on why Bear Stearns was rescued, Lehman
not, and then AIG rescued.
And if you could, be as specific as you can
about what is expected to happen if one of those
companies failed, why something you thought would happen
with Bear Stearns but you didn’t think would happen with
Lehman, and so forth.
MR. BERNANKE:

Yes.

So let me first say that

the toughest choice we made was the Bear Stearns action.
It was the first one.

And it came in the middle of a

very sharply intensifying financing crisis in March of
2008.

What we were seeing at that time was exactly this

cycle of worsening haircuts, that is, where the
financing -- so that Bear Stearns was the weakest of the
six or five investment banks.

The investment banks

relied on this repurchase agreement, overnight tri-party

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repo financing model.

And this is when that model was

really beginning to break down.
And as the fear increased, the lenders, via
the tri-party repo market and other short-term lending
markets, again, began to demand larger and larger
haircuts, premiums, which was making it more and more
difficult for the financial firms to finance themselves
and creating more and more liquidity pressure on them.
And it was heading sort of to a black hole.
Considered at the time of Bear Stearns -- and
I think we’ll want to give you a much fuller answer at
some point -- was that the collapse of Bear Sterns might
bring down the entire repo market, the entire tri-party
repo market, which is a two-and-a-half trillion-dollar
market, which was the source of financing for all the
investment banks and many other institutions as well.
Because if it collapsed, what would happen would be that
the short-term overnight lenders would find themselves
in possession of the collateral, which they would then
try to dump on the market.
in asset prices.

You would have a big crunch

And probably what would have happened

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would -- our fear, at least -- was that the tri-party
repo market would have frozen up.

That would have led

to huge financing problems for other investment banks
and other firms; and we might have had a broader
financial crisis.
It helped that we had a solution which was
obviously not a perfect solution, but -- in fact, what
we thought we had was a solution that didn’t involve
any government money, which involved a merger, an
acquisition by J.P. Morgan of Bear Stearns.
In the end -- as you know, we came down to the
end -- and in the end, we ended up financing $30 billion
of assets to moderate the risks associated with the
acquisition for J.P. Morgan.

At that time, I think we

had sort of felt that we were committed to doing this,
and we were fearful of the effects on the tri-party repo
market on financing in general of a collapse of
Bear Stearns.
And, you know, following the rescue, the
markets did improve quite a bit.

Then we had for a

number of months a considerable increased stability in

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funding markets.
So that was a very important decision.

We

made that collectively, that including, of course, the
Treasury Department.
And again, to answer your question most
directly, I think we were primarily focused on the
potential collapse of the short-term funding markets,
particularly the overnight repo markets and tri-party
repo markets, which would have created a contagion to
many other firms.
Subsequently, of course -- we didn’t mention
Fannie and Freddie, but Treasury took over Fannie and
Freddie.

We felt at that point, you know, that the

implicit guarantee of the government on all of Fannie
and Freddie’s MBS and debt was there, and that this was
so globally held in such large amounts, that the loss of
confidence in that would have basically been a huge
problem for the stability of the financial system.
We were able to do that because Congress had
passed a month earlier, it passed the HERA law, which
gave the government the authority to go in, and the

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Federal Reserve was supportive of FHFA and the Treasury
in its operation, which I think, you know, was at least
successful from the perspective of stabilizing the firms
and avoiding financial calamity.

But, of course, it’s

been very expensive.
So now we come to this very intense period in
September and October.

As a scholar of the Great

Depression, et cetera, et cetera, I honestly believe
that September and October of 2008 was the worst
financial crisis in global history, including the Great
Depression.

If you look at the firms that came under

pressure in that period

-- if the five large investment

banks, they all came under serious pressure, of the five
biggest commercial banks, only one, J.P. Morgan, was not
at serious risk of failure.

Fannie and Freddie, AIG.

So out of maybe the 13 -- 13 of the most important
financial institutions in the United States, 12 were at
risk of failure within a period of a week or two.
Globally -- I gave a speech in Jackson Hole in
August, which sort of tried to put a global perspective
on this.

And the fact is that globally, somewhere in

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the order of 15 to 18 major firms were bailed out,
rescued, saved by their governments in Europe and in the
UK.

So it was very much a global phenomenon, and in

that respect also extraordinarily important.
So let me say now for the record, for the
tape -- you know, I’ve said the following under oath and
I’ll say it again under oath if necessary -- we wanted
to save Lehman.
Lehman.

We made every possible effort to save

We sent –- we called together –- we had a

meeting together all weekend at New York Fed in New
York.

We asked the CEOs of all the major firms to come

to New York Fed.

We worked with them.

We had two

possible buyers.

We worked with them.

We met with the

risk managers and the other senior staff of the major
financial firms.
We knew -- we were very sure that the collapse
of Lehman would be catastrophic.
about that.

We never had any doubt

It was going to have huge impacts on

funding markets.

It would create a huge loss of

confidence in other financial firms.

It would create

pressure on Merrill and Morgan Stanley, if not Goldman,

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which it eventually did.

It would probably bring the

short-term money markets into crisis, which we didn’t
fully anticipate; but, of course, in the end it did
bring the commercial paper market and the money market
mutual funds under pressure.

So there was never any

doubt in our minds that it would be a calamity,
catastrophe, and that, you know, we should do everything
we could to save it.
We could not.
authority to save it.

We did not have the legal

And I will explain the difference

between Lehman and AIG in just a moment.
We made every effort possible.

But when the

potential buyers were unable to carry through, in the
case of Bank of America, because they changed their
minds and decided they wanted to buy Merrill instead in
the case of Barclays, because they didn’t really have
the financial strength to do it and their regulator was
not willing to go along -- and there are other legal
impediments as well which I can get into -- we
essentially had no choice and had to let it fail.
Two days later, AIG, again, we felt that its

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failure would threaten the stability of the global
financial system.

Among other things, they had as

counterparties many of the world’s largest bank
financial institutions, many of the world’s largest
banks.

The uncertainty in the markets about the

financial impact of the collapse of AIG on so many large
financial institutions in this period of intense crisis
already, plus the impact on insurance markets,
et cetera, et cetera.

And, again, we could provide you

much more detailed documentation on exactly what our
analysis was and how we worked through this.

But we

were, again, very, very concerned that the failure of
AIG would have enormous consequences for the global
economy and global financial stability.
Now, why AIG and not Lehman?

The problem

was -- well, to give you a broad perspective, around the
world, the United States was the only country to lose a
major firm.

Everywhere else, countries were able to

come in, intervene, prevent these failures.
And I think, politically speaking, this is one
place where the parliamentary system probably worked

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better because the prime ministers and the parliamentary
leadership were able to get together over the weekend,
make decisions, and on Monday morning, able to take
those choices.

And, generally speaking, the central

banks, although they were involved in Switzerland and
other places, in finding solutions, were not leading the
efforts to prevent the collapse of these institutions.
But in the United States, as you know -- of
course, we don’t have the political flexibility for the
government -- quote, unquote -- to come together and
make a fiscal commitment to prevent the collapse of a
firm.

And so basically, we had only one tool, and that

tool was the ability of the Federal Reserve under 13(3)
authority to lend money against collateral.

Not to put

capital into a company but only to lend against
collateral.

That, plus our ingenuity in trying to find

merger partners, et cetera, was essentially all -- that
was our tool-kit.

That’s all we had.

In the case of AIG, the reason AIG was set up
the way it was originally, the financial products
division, which did the CDS, attached itself to AIG

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precisely because it was a large, highly-rated insurance
company with lots of assets.

Therefore, it could sell

CDS without what would otherwise be sufficient
capitalization and protections because the
counterparties would know that this was a highly rated
firm with lots and lots of assets.

It was precisely

because of that reason when financial products had to
sell -- had to come up with collateral and was facing a
run on its positions, that the Fed -- that there existed
the collateral, the assets, that the Fed could lend
against.
So we were able to –- we made a loan -- we
didn’t put capital in, we made a loan against the assets
of the entire company.

And the fact that they had the

collateral put up, meant that we were able to put in the
cash liquidity that allowed them to pay off their
collateral that diverted the bankruptcy.
In the case of Lehman Brothers, there was just
a huge hole.

I mean, they were insolvent and they had

a thirty- to forty-billion-dollar hole in their capital
structure.

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At one point, we got an offer from Bank of
America.

They said, “We’ll buy them if you’ll

finance” -- I’m making up numbers now, but rough order
of magnitude –- “if you’ll finance an $80 billion
portfolio for $80 billion,” except its actual market
value was $50 billion.

So in other words, they wanted a

$30 billion gift, essentially, in order to make that
acquisition.

We did not have the legal authority to do

that, not to mention the political backing.
Vice Chairman Thomas: And you wouldn’t have
done it, anyway.
MR. BERNANKE:

That’s right.

And it would

have been a bad decision, anyway, because we had so
much -– so many other firms already on the brink, coming
down the pike.

So I will maintain to my deathbed, that

we made every effort to save Lehman, but we were just
unable to do so because of a lack of legal authority.
I also want to say a couple other things
really quickly -- I know this is taking too much time on
this topic, but it’s obviously a very important one.
First, is that “viewed too big to fail” is a

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very, very serious problem, and one that was much bigger
than was expected.

And I think it’s absolutely critical

that if we do only one thing in financial reform, it is
to get rid of that problem.
firms to fail.

It has to be possible for

But in the context of the financial

crisis last fall, it was our judgment, which was -- in
my opinion, was vindicated by subsequent events, that
the collapse of one of these firms would have had very
serious effects, not only on other financial firms but
on the whole economy.
The other comment I would make is that there
is a view out there which says, “Well, the problem
wasn’t the failure of these firms, but the fact that
people didn’t know what to expect.

People thought that

Lehman was going to be protected and, therefore, when it
failed, it was a huge shock, and that led to the
worsening of the crisis.”
of this point of view.
basis.

I find -- I’m very skeptical

I don’t think it has any real

And I would just point out as evidence that

prior to Lehman’s failure, the CDS spreads were blowing
out, that everybody -- every creditor was running to

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pull their money out of Lehman.
plummeting.

The stock price was

This doesn’t sound like a situation where

people thought that Lehman was going to be protected.
There was truly a lot of uncertainty, a lot of fear that
Lehman would not be protected.

And, in fact, it was

that very fear and uncertainty that forced us into the
situation in the first place.
So while I certainly recognize that the
rescues were not done in the cleanest way one could
imagine, I plead two points:

One is that we just didn’t

have the powers; we did the best we could with the
limited authorities we had; and, secondly, that I think
the events have vindicated the view that, while it was
an extraordinarily unpleasant situation and one where we
shouldn’t have been in in the first place, the failure
of those firms, particularly Lehman, created a huge
amount of chaos in the financial system which spilled
over to

a very sharp decline in economic activity

around the world.
CHAIR ANGELIDES:

Thank you.

Douglas?

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COMMISSIONER HOLTZ-EAKIN:

I want to go to

this notion of a gap in the regulatory structure.

If

you could bring the clock back to where there was a
macro prudential regulator, what would they have done
that would have helped you and how would they have
identified the “too big to fail” folks?
MR. BERNANKE:

Well, I think the most

elementary thing they could have done would have been to
put together a list of the biggest, most complicated
central firms.

Anybody on Wall Street could put that

list together in 30 minutes.

And then they should have

reviewed -- they could have reviewed the system of
supervision for each one of these firms and had asked
for reports on what are the principal risks, you know,
within these firms, et cetera.
So, again, the case that keeps coming to mind
is AIG.

I think a careful review from a systemic point

of view of the major institutions would have identified
AIG very quickly as being one where there was not
adequate protection against not only the firm’s own
safety, but for the system as a whole.

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COMMISSIONER HOLTZ-EAKIN:

But one of these –-

I just want to understand this -- is that no one could
understand basically the panic in the tri-party repo.
That the run on the repo market really is what drove the
spreading of the crisis.
Would anyone have been able to anticipate
that?

You didn’t seem to.
MR. BERNANKE:

No.

So maybe not.

Maybe not.

I mean, I think a thorough review of the system would
have identified this as a critical piece of
infrastructure that required careful attention.

But

it’s possible that it might not have been identified
specifically.

But, of course, that was then, this is

now.
COMMISSIONER HOLTZ-EAKIN:
MR. BERNANKE:

Right.

We now have the benefit of the

crisis.
You’re absolutely right, I mean, that there’s
no guarantee that a macroprudential approach will
identify every possible crisis.

But clearly, where we

can, we want to strengthen the system, we want to create

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as many ways of identifying problems as possible.

And

a lot of what is proposed, for example, by the
Administration, the Fed, and others, is about making the
system stronger, and strengthening the infrastructure,
central counterparties, et cetera, so that no matter
what happens, whether it’s a 9/11 event or whatever, the
system will be more resilient and able to deal with
whatever kind of shock occurs.
CHAIR ANGELIDES:

Byron.

COMMISSIONER GEORGIOU:

Back in last

September, when you created -- you began to supervise
Goldman Sachs as a single bank holding company at the
Fed.

Do you regard that as a temporary condition or a

permanent one?
it end?

And if temporary, you know, when would

If permanent, what steps are being taken to

reduce the risk?

How long will they have access to the

Fed window and so forth, since it’s an institution that
will be regarded as so large as to be required to be
protected forever?
MR. BERNANKE:

Okay, well, there’s several

parts to that.

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So, first of all, under current law, Goldman
Sachs is a bank holding company so under current law,
the Fed is the umbrella supervisor of Goldman Sachs.
Not under any special emergency provision, but under
current law.

And as long as they’re a bank holding

company, as long as the law is not changed, we will do
our best to be the umbrella supervisor of that company.
And I have to say, given what’s out there, that we are
the most qualified agency to supervise them.
Now, of course, there may be changes in that
structure, there may be changes that the -- Congress
may require changes in the complexity, size, all those
different things.

Those are things we can talk about.

You used the word “protection.”

My view is

that, going forward, that the firms that are
systemically critical -- and Goldman Sachs is one of
them -- should, on the one hand, receive tougher, more
comprehensive oversight than other firms.

Because not

only are they -- not only do we need to protect them
themselves, but because of the damage they would do to
the broader system if they collapsed.

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Moreover, tougher, more comprehensive
oversight, including higher capital liquidity
requirements and so on makes it less attractive to be
big.

And so only firms that have strong economic

rationales to be big would therefore be big.

And there

would be an incentive to shrink if, in fact, you could
escape some of this intrusive oversight.
The other part, though -- and, again, I just
want to say this as strongly as possible -- the reform
will be a failure if we could not contemplate the
failure of Goldman Sachs.

That is, there needs to be a

system by which Goldman Sachs will go bankrupt and
Goldman Sachs’ creditors could lose money.

If we don’t

have that, then we might as well treat them as a
utility, because that’s what they are.
COMMISSIONER GEORGIOU:
MR. BERNANKE:

Right.

So if we want them to be a free

capitalist company, then they have to be able to fail.
Vice Chairman Thomas:
MR. BERNANKE:
ways to do it.

Downsize.

We don’t have -- there are many

You can downsize them, many things --

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and we can discuss that, and certainly we’ll have plenty
of opportunity to discuss that.

But one way to do it,

is to have a special bankruptcy regime which comes in,
is not constrained in the same way that we were last
fall by these standard bankruptcy laws, and is able to
impose losses, is able to create a bridge bank that
allows the critical parts of the company to continue
functioning, is able to override existing collateral or
employment agreements, et cetera, et cetera, to avoid
any cost to the taxpayer but allow -- and avoid at least
severe damage to the financial system, but allow for
them to fail.

And I just think that’s absolutely

essential.
COMMISSIONER GEORGIOU:
in place yet.

But we don’t have that

So if something happened -- if we faced a

similar crisis today to what we faced two years ago,
we’re really not equipped to -MR. BERNANKE:

We are not.

That’s why we

must -- I think it’s important to deal with this as soon
as possible.
CHAIR ANGELIDES:

Senator?

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COMMISSIONER GRAHAM:

I’m concerned with the

difference between what is happening in the United
States and what has happened in certain European
countries relative to employment during this period of
financial crisis.

Were there some options that were

available that might have elevated the policy focus on
employment and had the potential of reducing the current
level?

And what were those options and if they existed,

and why were they not accepted?
MR. BERNANKE:

Well, I think, first of all,

you have to recognize that the crisis originated in the
United States, for the most part, although Europe and
the UK were also very much caught up in it.

And the

impact it had on our economy was greater than on most
other economies.

That’s a little bit of a complicated

statement because some countries like Japan had very
sharp declines after Lehman, but then they began to
bounce back.

So that the impact on the U.S. economy was

quite severe and quite broad-based.
We had sectors like the housing sector and so
on that shrunk and lost a huge amount of jobs just

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because that was part of the crisis itself.
The other thing I -- so the severity is a big
part of it.
Another part of it is that in Europe, in
particular, there are a lot of -- the labor markets are
different.

They are, generally speaking, more

regulated, which we have at various times viewed as
being a negative for them relative to us because
we’re -- they’ve had, for example, much higher average
unemployment for 25 years than the U.S. because the
markets are much less flexible, you can’t fire people,
therefore, you don’t want to hire them, and so on.

But

in this case, it looks like that those subsidies and so
on may be at least delaying some of the employment
effects of the crisis.

In particular, for example, in

Germany, firms are subsidized to keep workers on the
payroll, and they’re subsidized to use work-sharing,
short hours split among workers.
So the conventional wisdom from my German
colleagues, Bundesbank and so on, was:

Right, we

haven’t seen that much increase of unemployment in

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Germany yet, but we anticipate a big increase that will
go into 2011 and even beyond.
Now, recently, as the European economy looks
to be coming back some, they’ve become a little bit more
optimistic about where that’s going to go.

But I guess

my point still stands, that in the U.S., late ‘08 and
early ‘09, employers became very, very worried about the
broad economy, and they cut workers very sharply.

If

you look at a graph of the depth of recession against
the amount of unemployment loss, this one really stands
out.

Not only is this a bad recession, but even given

the depth of the recession, the employment loss is worse
than -- much worse than usual.

Now, that may mean that

things will snap back better, we don’t know, in the
future.
But in Europe, they didn’t have as big a cut.
And I think initially, at least, that was because of
government subsidies of various kinds.
Given that the economy now -- now there’s more
confidence that we’re not going into a second
Great Depression, and Germany and Europe, in general,

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are growing again, maybe they have avoided some of that
big, sharp decline.

But I don’t think I would want to

trade our labor markets, in general, for German labor
markets.

They’re less efficient and they have higher

average unemployment rates over longer periods.

But

they may have cushioned some of the effect of the shock
this time.
Vice Chairman Thomas:

The problem is, you

just increased that structural arrangement, which means
you carry it out over a longer period of time.
In part, along Bob’s line, you know how much
we tried to figure out how to deal with international
trade, and cooperation and the rest.

I think one of the

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

And Great Britain is looking at

doing some things to their banks far greater than we’ve

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begun to talk about doing, although maybe the impact
wasn’t as great.
Do you have any concern about how now, at
least knowing the reasons for it -- and we’re going to
try to go through a regulatory structure to help correct
that -- that there’s enough international discussion,
a willingness to cooperate, to create a structure so
that you don’t get the effects that we had?

Or do you

see people saying, “It was our fault, we’re lucky, and
we don’t need to worry quite as much as they do”?
MR. BERNANKE:

No, I think the Europeans and

the British, in particular, are quite taken by the
severity of the crisis, and they recognize that some of
the problems were homegrown as well as imported from the
U.S.
I would have to say that, broadly speaking,
financial regulation is one of those areas where there’s
more international cooperation than in almost any other
area of regulation.

You know, we regularly go to Basel,

they talk of the Basel Capital Committee, and they have
many other subcommittees and various other types, and

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there’s called the Financial Stability Board, which is a
body that brings together the regulators and the central
bankers from around the world.

So there’s a lot of

standard-setting and rules and so on which are set up on
an international basis.

And then each country has to

decide whether to implement them or not.
So there is a lot of coordination in that
respect, and I think that’s probably a good thing.
One area which is going to be a big problem,
though, is I’ve talked fairly optimistically about this
special resolution regime and bringing -- unwinding
global, large, integrated complex companies.
kind of imagine doing that.

We can

But one real big problem

is going to be coordinating that internationally.

What

happens if, you know, Citigroup has companies in a
109 -- has subsidiaries in 109 countries?
going to manage that?

How are we

That’s going to require a lot of

international cooperation, some development of some
treaties or other sets of rules that govern how we
coordinate on that.
If we can’t do that, then what may happen is

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that we may go to a world where large companies are
required to separately capitalize their subsidiaries in
each country.

So, for example, Citigroup owns Banamex,

which is a big Mexican bank.

Under the kind of

provision I’m thinking of, Banamex would have to have
its own capital, its own liquidity.

And so if there was

a failure, Banamex itself could stand on its own and the
Mexican government would worry about Banamex, and we
would worry about the rest of Citigroup.

Now, that

would actually greatly simplify the process of bringing
down and closing a global company.
The open question -- and I’ve heard arguments
on both sides -- is to what extent would that change,
reduce the ability of global firms to operate
effectively internationally, to bring capital across
borders, to operate as counterparties to international
firms, et cetera, et cetera, would that substantially
reduce the effectiveness of globalized finance?
it’s worth it, even if it does.

Maybe

But I think that’s

something we have to look at.
And as I said, people have different views on

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that.
Vice Chairman Thomas:

A quick follow-up on

that.
MR. BERNANKE:

Sure.

Vice Chairman Thomas:

If you take a look at

AIG, you had the ability by virtue of how successful the
rest of them were to go and put money in.
Was there any discussion about cutting that
leg off, since the rest of it was stable?

And if you

were worried about “too big to fail,” that cutting a leg
off isn’t failing?
MR. BERNANKE:

The financial products

division?
Vice Chairman Thomas:
MR. BERNANKE:
authority.

Yes.

That was not within our legal

The financial products was -Vice Chairman Thomas:

The only way you could

was to move -–
MR. BERNANKE:

The only way, what gave

financial products its AAA rating was the full faith in
credit, essentially, of the whole AIG company.

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Vice Chairman Thomas:
MR. BERNANKE:

Of the whole company.

There’s no way to say that

financial products is bankrupt without bringing down the
whole company, and that was the dilemma.
CHAIR ANGELIDES:

All right, Mr. Chairman, so

we obviously want to get the best understanding of what
occurred here in the sense we’re undertaking an autopsy.
So actually before you came in, we had a fairly robust
debate about the best way to slice this, to get the best
window on what happened.
One of the things you’ve talked about today
is you’ve talked a lot about institutions that have
systemic risks associated with them.

You talked about,

within institutions, institution-wide risk.

You’ve

actually talked a little bit about J.P. Morgan as an
institution conducting itself differently, I think, or
at least being the one out of 13 that didn’t have an
immediate liquidity, I guess, or cash pressure in that
particular window.
And then finally, you spoke about, on a
going-forward basis, your view that as you look at the

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marketplace, there’s particular attention to
institutions that have a systemic challenge.
So this is really -- it’s going to sound like
a process question, but it’s really trying to -- I’m
trying to figure out, as one commissioner and as the
chair, how we get the best look at what happened.
And I guess I’d ask you to inform us a little
about whether we ought to be looking at this as a set of
separate issue strands or product lines, or the extent
to which we’ve got to look at it on an institutional and
systemic basis.
And to what extent were these, in your view,
were the problems caused by specific lines of business
or was it the aggregation or the interaction of those?
And that’s kind of a sub of that.
MR. BERNANKE:
it’s the latter.

I think, unfortunately for you,

I think, one of the --

CHAIR ANGELIDES:
MR. BERNANKE:

The latter being?

The integration, the

interaction of all these different factors.
So one of the reasons -- so, again, I fully

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admit that I did not forecast this crisis.

And in

defense, for what it’s worth, is that, again, if you
just thought about this as a subprime mortgage crisis -I mean, clearly, you want to understand why subprime
mortgages did what they did and why they were such a
problem and so on.
per se.

But it wasn’t subprime mortgages

Subprime mortgages were just the trigger that

set off a whole bunch of other bombs.
So I think -- what’s the name of the author
who wrote “Airport” and -CHAIR ANGELIDES:
MR. BERNANKE:
writes his books?
characters.

Hailey?

Yes, yes.

So you know how he

You know, he’s got these different

You know, there’s this long discussion of

Character A, and then completely separate, Character B,
and then all of a sudden at the end there’s some kind of
huge crisis and they’re all squished together?
CHAIR ANGELIDES:
MR. BERNANKE:

I’ve only seen the movie.

All right.

So I think

because the -- I think the only way to do this, from my
perspective, would be to identify major topic areas, the

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macroeconomic context, evolution in the types of
businesses, and their risk management, et cetera.
CHAIR ANGELIDES:

What do you mean by “types

of business”?
MR. BERNANKE:

I mean, how does Goldman Sachs

look different today than it did ten, 15 years ago, and
why?
CHAIR ANGELIDES:
MR. BERNANKE:

Okay.

And how did they manage the

risks that –- the risks, liquidity issues, and so on -how did that all change, and was it created by
innovations of various kinds, was it a function of
regulatory change, et cetera?

What was happening to the

regulatory framework over this period?
I would talk about the shadow banking system;
I would talk about supervision.
Vice Chairman Thomas:

The perfect storm of

all of these.
MR. BERNANKE:

And it’s a perfect storm, is

what it was.
And then after having laid out how each of

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these areas evolved, and what the main forces were, then
if I were doing it, I would then sort of do a kind of a
narrative and sort of say, how did these things interact
with each other to create this perfect storm?

And I

think unless you identify it, there’s no single simple
thread, linear thread, that will let you do it.

You’ve

got to identify the major categories of developments and
then talk about how they -- how factor X -- so in our
case, what’s the connection between Lehman Brothers and
General Motors?

Lehman Brothers’ failure meant that

commercial paper that they used to finance went bad,
which meant that the reserve fund which held the Lehman
commercial paper broke the buck, which meant there was a
run in the money market mutual funds, which meant the
commercial paper market spiked, which was problems for
General Motors.

So these connections are very complex,

and the only way to do it is to understand the main
threads and then to try to tell the narrative.
Vice Chairman Thomas:

I find it’s fairly easy

after the facts.
MR. BERNANKE:

Well, after the facts, yes.

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CHAIR ANGELIDES:

And I want to ask one

follow-up.
To what extent do these come together in
certain mega-institutions -- these threads?
MR. BERNANKE:

Well, I mean, clearly, the

mega-institutions were the focus of the crisis.
that’s not a necessary thing.

I mean,

We’ve had other crises,

like the savings and loan.
CHAIR ANGELIDES:

But in this one.

In this

one.
MR. BERNANKE:

In this one -– I’m saying, but

in this one, the mega-institutions were, in some sense,
the heart of the crisis.

And all the things I’m talking

about, one way or another, impacted on their stability
and on the stability of the system.
So there were things like over-the-counter
derivatives trading and things of that sort, which
reflect interactions between firms.

There were some

medium-sized firms that were involved, the Indy Macs and
the WaMus and things like that.

But basically, it was

the complexity of large firms.

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And think of it as -- and, again, it was our
-- but it was part of our problem, that we were looking
at this firm and saying, “Citigroup is not a very strong
firm, but it’s only one firm and the others are okay,”
but not recognizing that that’s sort of like saying,
“Well, four out of your five heart ventricles are fine,
and the fifth one is lousy.”

You know what I mean?

They’re all interacted, they all connect to each other;
and, therefore, the failure of one brings the others
down.
CHAIR ANGELIDES:

All right, Heather?

COMMISSIONER MURREN:

Actually to follow on

that thread, there’s been a lot of discussion about the
term “systemically important” or “system risk,” but I
haven’t seen anyone define it yet.

And what

characteristics would you say would define a financial
institution that is systemically important and how would
you measure those?
MR. BERNANKE:

That’s a great question.

There is some research that does that, and
there’s some papers.

I think the Cleveland Fed has some

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papers.

There were a number of articles out there that

try to do it.
you.

We can probably dig some of that up for

So people have taken a serious hit at this.
One lesson from those exercises is that simple

size, for example, is not enough.

That’s one of the

reasons that just having a size limit on firms is
probably not adequate.
So by definition, a systemically critical firm
is one whose failure would create broad problems for the
financial system and the economy.

And then you want to

think about the mechanisms for that happening.
One would be size and, therefore, the number
of counterparties that it has, the number of customers
and counterparties and creditors and so on that it has.
That’s certainly one dimension of it.

Another element

with the word that comes up a lot is interconnectedness.
Which means, for example, Bear Stearns, which is not
that big a firm, our view on why it was important to
save it -- you may disagree -- but our view was that
because it was so essentially involved in this critical
repo financing market, that its failure would have

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brought down that market, which would have had
implications for other firms.
COMMISSIONER MURREN:

So a disproportional

involvement in a particular segment of the financial
markets would be the way to define that?
MR. BERNANKE:

Particularly -- so there are

parts of the system which you can call the plumbing or
the infrastructure, and those have to do mostly with
funding, financing, or simply trading in and price
discovery and clearing and settlement.

Anything that

threatens the integrity of those infrastructure things
is very dangerous.
So, fortunately, J.P. Morgan was pretty
stable.

But J.P. Morgan actually is the bank that

runs -- one of the two banks -- that runs the tri-party
repo market.
J.P. Morgan’s failure would have been a huge
problem because that market would have essentially been
inoperative because there are only two banks that run in
that market, and they don’t have compatible computer
systems.

So that’s an example.

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Another example is AIG -- well, so AIG is big.
But I’ll give you a smaller one, like some of these
companies that were mortgage insurers, which are pretty
small companies.

But, you know, their failure required

by accounting rules would have forced the markdowns -serious markdowns of many of their counterparties who
had used them to insure their mortgage positions, for
example.

So they were connected to a large number of

other firms.
And then I think -- so size,
interconnectedness -- size in terms of both assets,
liabilities.

Interconnectedness in terms of the

creditors, the connection to key markets and
infrastructure.

And then the third would be provision

of critical services, like the J.P. Morgan example.
One of the -- this is an example from 1987 -but one of the things that was of real concern during
the ‘87 stock-market crash.

Stock-market crashes don’t

usually cause problems in an economy.

But one of the

concerns was that losses be taken by participants in the
Chicago Exchange, which traded the stock-market futures

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might have caused the failure of the exchange.

And the

Fed was involved 22 years ago in making sure that banks
were providing sufficient credit to the exchanges and to
their participants to make sure that didn’t happen,
because the collapse of the exchange itself, which after
all was a company, would have had, I think, very serious
implications.
So companies that either are closely tied to
or perform critical market functions, like exchanges or
clearinghouses, are also very important.
One of the -- just a plug, one of the things
that the Fed has asked for, and is in the Administration
proposal, is to have a more consistent system of
prudential oversight of critical infrastructure,
payments and settlement systems, which currently we have
a very patchwork kind of system where can we have
different overseers for different types of exchanges and
so on.
So, anyway, there are attempts to measure
systemic risk.
Another criterion that’s been used by some

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scholars is correlation.

If the stock price of this

company falls, what happens to other stock prices?

If

it’s highly correlated, it might suggest there’s a
connection and correlation across those firms.
It’s obviously not rocket science, but there
is some work trying to do that, and I was just trying to
identify some of the key ones.
COMMISSIONER MURREN:
CHAIR ANGELIDES:

Thanks.

Keith.

COMMISSIONER HENNESSEY:
focusing a little more narrowly.

Derivatives, just
Obviously, credit

default swaps were a big concern as a transmission
mechanism, and then obviously the toxic assets
themselves were asset-backed and mortgage-backed
securities and CDS and all those.

But there are lots of

other kinds of derivatives that I never remember
coming -- you know, stock options, interest-rate swaps,
and currency swaps, all of those other kinds of things.
To the extent that there were specific
problems over the last couple years, were they just in
CDS -- I’m sorry, within those universe of derivatives,

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was it CDS and asset-backed securities, or were there
broader problems or problems with other subsets of the
derivative world?
MR. BERNANKE:

I think the biggest problems

were in those two categories you mentioned.

There are

two related -- well, the problems that arose were,
first, where derivatives, for whatever reason, were
thought to be creating risk-sharing and they weren’t for
one reason or another -- and so the complexity of the
derivatives positions.
In some cases, you know, for banks, we have
simple leverage ratios.

For hedge funds and so on, it’s

almost impossible to figure out what their true leverage
is because derivative positions create effective -- you
know, de facto leverage, and so on.

So figuring out

exposures and leverage and so on is much more
complicated because of the derivatives and the
inability -- more particularly, the inability of the
firms themselves -- in principle, you could model for
different scenarios, for different kinds of shocks, you
know, how your position would change, taking fully into

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account all the derivatives positions.
done well.

But that wasn’t

And so it was a layer of complexity.

It

wasn’t really fully accommodated by the risk management.
So that’s one element.
COMMISSIONER HENNESSEY:

So just to repeat,

that said, the two that I described, and then a general
problem of measurement having to deal with leverage
ratios and capital, right, which is -- it’s hard to
value the derivatives -MR. BERNANKE:

Right.

COMMISSIONER HENNESSEY:

-- to figure out how

much from X is leverage.
MR. BERNANKE:

Right.

COMMISSIONER HENNESSEY:
MR. BERNANKE:

Okay.

Now, the other problem, though,

which distinguishes credit default swaps from interest
rate swaps, for example, has to do with how they are
traded and cleared.

So the CDS market grew really,

really quickly from nothing, and didn’t have an
appropriate infrastructure for -- I mean -- to give Tim
Geithner credit, when he was at the Federal Reserve Bank

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in New York, the Federal Reserve Bank in New York was
working really hard on a voluntary basis with all the
CDS dealers in New York to try to set up a rational
system just for keeping track of trades.

I mean, they

were doing everything on paper, and it was days behind
and nobody knew who owned what or who owed what to whom.
They were assigning contracts to others without telling
the original -- et cetera, et cetera.
So just the basics of having a well-working
infrastructure for trading, clearing, and settlement was
missing in that huge, rapidly expanding sector.
Vice Chairman Thomas:

So I can stay with you

on this -MR. BERNANKE:

Yes.

Vice Chairman Thomas:
so rapidly?

-- why was it expanding

Because there was no tent to put it under?

MR. BERNANKE:

Well, it’s actually a -- from a

finance theory point of view, it’s actually a very
clever instrument.
Vice Chairman Thomas:
MR. BERNANKE:

Oh, yeah?

What it does, it allows you

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very cheaply and efficiently to insure yourself against
the credit risk of a particular firm or even an index of
firms.

So -Vice Chairman Thomas:

Give me -- in theory?

In theory or in reality?
MR. BERNANKE:

Well, in reality, if you use

them right.
So to give you some examples, if you’re making
a big loan to Ford, you want to protect yourself, you
can buy some, you know, credit default swaps that pay
off before it goes bankrupt as a way of hedging.

So in

principle, it should help you manage your risk.
More generally, you know, it’s kind of
expensive to buy and sell corporate bonds.

You can

buy it -- it’s much cheaper to buy and sell to CDS,
which have the same risk.

And if you want to bet on

Ford, instead of buying a Ford bond, you can just insure
Ford against –- you know, insure against Ford credit
risk.

It’s essentially the same bet.

It’s the same

reason why people use S & P futures instead of trading a
basket of 500 stocks.

It’s just much more efficient to

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do it that way.
So -- or even more generally, suppose that you
have bought a lot of stock in auto-parts makers.

You

can hedge that by appropriate CDS, you know, bets on
Ford and GM, which are going to be correlated in certain
ways.
So it’s a very -- in principle, it’s a very
efficient instrument.
Vice Chairman Thomas:

And, therefore, used by

a lot of people very quickly.
MR. BERNANKE:
very quickly.

Used by people, and grew very,

And became -- frankly, the regulators

probably didn’t help here.

Because in the sort of

capital regulation of banks, to the extent that banks
can show that they have hedged their risks, they can
hold less capital.

So if I made a loan to Ford and I

have a credit default swap that protects me against
Ford’s loss, I could say, “Well, I don’t have to hold
any” -- but, of course, the other problem here, besides
just the primitiveness of this system in which they
cleared and settled, was that the counterparty risk

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wasn’t taken into account.
So people who lost -- you know, you could lose
money because you took a bad position on Ford, but you
could also lose money because you made that bet with AIG
and they couldn’t pay off.
So the advantage of interest-rate swaps, for
example, is that they are traded on sophisticated,
mature exchanges where everybody knows what the price
is, the price discovery process is clear, the clearing
and settlement is well-understood, rapid.

And most

important, there being a central counterparty, you don’t
have to know who you’re trading with because the central
counterparty will, through use of margins of capital,
et cetera, will make sure that if your counterparty
fails, you won’t even know it, you’ll still get paid
off.

And that would have -- you know, those kinds of

arrangements, so long as those counterparties themselves
are well-managed and have enough capital, et cetera.
Because if they fail, then you’re really in trouble.
That protected the -- so that the CDS, a new instrument,
did not have the same level of counterparty protection,

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exchange, and so on, as mature instruments like
interest-rate swaps.
COMMISSIONER HENNESSEY:
CHAIR ANGELIDES:

Thanks.

All right, Brooksley.

COMMISSIONER BORN:

Thanks.

We have talked a lot about -- and you’ve
talked a lot -- about the need for a systemic risk
supervisor and the need to understand the exposures of
big institutions and their interconnectedness.
I’m a little concerned still about systemic
risk that comes from financial products or financial
markets that aren’t adequately seen or understood by a
banking supervision kind of institutional approach.
I wish you’d comment on that.

And

I mean, nobody really,

totally saw the problems with securitization or OTC
derivatives.
MR. BERNANKE:

Right.

So -- I actually gave a

speech about that.
So financial innovation we all thought was a
great thing -- or maybe we didn’t think it, but most
people thought it was a great thing.

But it obviously

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had a downside, which like any other invention, it can
blow up if it hasn’t been safety-tested sufficiently.
And that clearly turned out to be an issue in the
consumer level, for example.

You know, there was a lot

of -- there are a lot of people who argued that subprime
mortgages were a big innovation, that they allowed
people who couldn’t otherwise afford homes, to get
homes; and, you know, it was a wonderful thing.

So

clearly, you know, people didn’t understand the
vulnerability of, say, 3/27 ARMs to a downturn in house
prices, for example.
So I guess what I would -- this goes back to
my answer to Doug, which is that I do not think that
there’s any foolproof way to avoid financial crisis in
the future, although we could do all we can to make them
smaller and less damaging.
But I would think that there would be some
regular process -- I don’t want to be too prescriptive
here -- but where, say, a consumer agency would look at
new consumer products and sort of look at them, anyway,
where regulators would look at big innovations in types

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of financial products, financial instruments.

And not

so much to be –- I don’t necessarily mean to say that
the regulator would say, “You can’t do this one.”

The

key is that if you’re going to introduce some kind of
product with complicated payoffs, that you are able -that you can measure the risks associated with it in a
very satisfactory way, both to your own satisfaction and
to the satisfaction of the regulator.
So, yes, I think we need to have a somewhat
more balanced view about the effects of financial
innovation, that there are times when it can be
dangerous.

And, again while, without promising, by any

means, that we can identify all the problems, at least
some attempt to look at things and road-test them and
look at how they interact with other markets and ask
some hard questions, would be at least a step in the
right direction.
CHAIR ANGELIDES:

Finally.

COMMISSIONER THOMPSON:

So no calamity of this

magnitude occurs without there being some early signals
that something’s going wrong.

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In the case of this calamity, what were the
signals?

Why did we -- and had we acted on them, might

we have averted the disaster?
MR. BERNANKE:

Well, I don’t know, I have to

think about that.
I think there were people -- there were people
saying -- including people at the Fed but others as
well -- saying, in the year before the crisis, that risk
was being underpriced, that spreads were very narrow,
that markets seemed ebullient, that liquidity was, in
some sense, excessive.
There were -- you know, the way I would put it
is, I think there were people -- not necessarily the
same people -- identifying various parts of the
problems.

You know, there were people who were

concerned about derivatives, there were people that were
concerned about subprime mortgages, there were people
concerned about the overall credit environment, there
were people who were concerned about off-balance-sheet
vehicles.
But I think notwithstanding the claims of one

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or two people out there who are now sort of living on
the fact that they, quote, anticipated in the crisis,
I would still say that the interaction of these things,
the “perfect storm” aspect was so complicated and large,
that I was certainly not aware, for what it’s worth -and it could be just my deficiency -- but I was not
aware of anybody who had any kind of comprehensive
warning.
There are people identified -- and the trouble
is -- and particularly in this blogosphere we live in
now -- at any given moment, there are people identifying
19 different problems, crises.
Vice Chairman Thomas:

And they may be right

at some point.
MR. BERNANKE:

And this is the thing, one of

them is probably right, but you don’t know who in
advance.

So that’s something you ought to look into.
But I would be very skeptical -- there are

people like -- you know, even -- take somebody like
Robert Shiller who is now pretty famous for identifying
the stock market and the housing bubbles; right?

A

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great economist.

I have great admiration for him.

a very serious guy.

He’s

But he identified the stock market

crash when the Dow was at 7,000.

So it went a lot

further after that.
And he was pretty open-minded in 2002, 2003,
whether there was a housing bubble or not.
So people that, quote, identify a problem, but
they don’t get the timing and the magnitude right.

So I

welcome your -- you know, your attempts to unravel this.
Again, consistent with what I’ve been saying,
which is that a consistent systemic risk council would
probably be able to identify some of these things and,
you know, approach it systematically and so on.
So while I can point to a number of different
things that various people said, I don’t know of anybody
who really anticipated the -COMMISSIONER THOMPSON:

So there were no

actionable signals?
MR. BERNANKE:
true.

Well, no, I don’t think that’s

I mean, I think -- well, so it’s always a

question from a legal perspective, if you’re trying to

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figure out intent, and da, da, da, what did you know and
when did you know it.

It may be that very few people

fully appreciated the risks of subprime lending in 2001
or 2002.
If we had been smarter or more systematic,
might we have identified them?

Possibly, yes.

So I think rather than saying, you know -obviously some folks are going to come out looking bad
or whatever based on what they saw or didn’t see.

But

I think instead of relying on the future on particularly
perspicacious financial geniuses who identify these
problems accurately in advance, I think we just need to
have a more systematic government or whatever structure
that will at least make an attempt to look at the
possible problems and -Chairman Angelides:

Can I ask a quick

follow-up to what he said?
So what you said earlier, J.P. Morgan out of
13 was in a different position.

Was there something

that they saw or did that was definitively different in
terms of market practice as an institution?

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MR. BERNANKE:

So J.P. Morgan was never under

pressure, to my knowledge.
Goldman Sachs, I would say also protected
themselves quite well on the whole.
of capital, a lot of liquidity.

They had a lot

But being in the

investment banking category rather than the commercial
banking category, when that huge funding crisis hit all
the investment banks, even Goldman Sachs, we thought
there was a real chance that they would go under.
So I think the answer is that there were folks
like Jamie Dimon, who -- you know, there is this classic
thing that Chuck Prince said about having to dance when
the music is playing.
attitude.

But that was exactly the wrong

I mean, basically, if you were thinking about

a longer-term -- a longer-term stability to your
company, you want to think about what you have to do to
make sure you’ve got plenty of reserves and protection
against bad events and so on.
So there were some -- obviously, this -- to
quote somebody else, Buffett:
you see who is swimming naked.”

“When the tide goes out,
This was the thing that

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really separated the sheep from the goats.

And the

really strong people who really protected themselves
came out better, and the ones who were relying on the
general boom to sweep them along, they were exposed.
CHAIR ANGELIDES:

Doug.

COMMISSIONER HOLTZ-EAKIN:

I want to ask the

flip side of John’s question on the actions that could
have been taken and just to toss you the softball to
sort of just address this narrative, that it was the
Fed/Treasury policy and these actions that made this
worse.

And I think you know this story:

Rates too low

for too long, creating a housing bubble, failure for
supervision oversights, standards on mortgage
origination, misdiagnosing a counterparty risk, lack of
transparency and liquidity problems, the notion that
post-Lehman credits were in fact tightening, markets
recovering, and then the TARP request comes, and then
the things explode.
How do you respond to that?
MR. BERNANKE:

Okay, so –--

COMMISSIONER HOLTZ-EAKIN:

Just quickly --

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Vice Chairman Thomas:

Just a conspiracy ball

of wax.
MR. BERNANKE:

Just very quickly, I think the

answer is –COMMISSIONER HOLTZ-EAKIN:
MR. BERNANKE:

A softball, huh?

Well, this will go into more

detail.
COMMISSIONER HOLTZ-EAKIN:

We could get more

later.
MR. BERNANKE:
some mistakes.

I think the Fed -- the Fed made

But I think the current attitude in

Congress that somehow the Fed is now the scapegoat, I
think that’s quite unfair.
The Fed, I don’t think that our interest-rate
policy was a big source of the problem, both because I
don’t think it was obviously the wrong policy, and also
because, again, as I said, if the system had been
incredibly fragile, you know, it wouldn’t have caused
anything.
We are, to some extent, culpable for not doing
the subprime mortgage regulation.

Small defense.

The

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system was set up in a crazy way, which was we were
supposed to make rules for mortgage brokers, et cetera,
which we do not examine nor regulate.

So it was a

little hard, the visibility issue was a little bit of a
problem.
that.

But nevertheless we did have ways of knowing

And Graham, Luck and Greenspan should have gotten

together and done something about that.
Supervision:
supervision.

We did a relatively good job on

If you look at the companies that failed,

I think the OTS did the worst, and the SEC did the
second worst, frankly.

And the Fed didn’t do a perfect

job, but -- and lots of things that we see now that can
improve and are improving.

But I don’t think we were

particularly culpable on the supervision part relative
to the rest of the world.
On -- let’s see, what else should I have?
COMMISSIONER HOLTZ-EAKIN:
MR. BERNANKE:

One big softball.

So I do -- I mean, I do believe

that we were incredibly handicapped by lack of proper
authorities in that the “too big to fail” problem, while
extremely unattractive, was there, it was a real

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problem.

I did, on numerous occasions, ask for better

authorities in advance of Lehman, including in June of
‘08, for example, in a speech with FDIC.

But it’s

clearly even ex post, you see it’s not coming.

So

ex ante was never going to come.
So I think, you know, we live -- we were in a
battlefield, and I think we did the best we could.
I know there are people, probably even on this
commission, who believe that Lehman could have been
allowed to fail without -- or Bear Stearns -- without
real consequences.

I don’t believe that myself.

I base

it on historical knowledge, and I base it on our
detailed analysis of the individual markets and
interactions.
And I’ll say one other thing about that, which
is that, in looking at AIG -- think about this in a
cost-benefit perspective.

Looking at AIG, I thought to

myself -- and I believe now -- that if we let it fail,
that the probability was 80 percent that we would have
had a second depression.
Suppose you believe it was 5 percent.

I don’t

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think any rational person could say it was less than
5 percent.
How much would you pay to avert a 5 percent
chance of a second depression?

$5 billion?

That’s

probably what we’ll end up paying.
So I think that those are the right decisions
to make, and we did the best we could given the limited
powers we had.
So a mixed record, but I think we played
important roles in saving the situation.

And I hope

we’ll play an important role in trying to get

an

improvement in our structure so that in the future we
won’t have a problem.
Vice Chairman Thomas:

I know you will answer

this from your current job because you’ve had so many
different ones and you’ve also been able to step back
and take a look at it.
One of the things that shocked us on the 9/11
information and the rest was not that we didn’t have
structures gathering information, but the absolutely
incredible inability to communicate so that you had an

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overall picture.
One of the main points you mentioned was the
global savings plan.

I mean, you know, you’re watching

your monetary drop, we used to watch our fiscal drop.
Now, here was this -- somebody was accounting for it,
somebody was examining the profile and sovereign funds
and the rest.
Was there any real collection of the amount of
money coming in, where we were turning little, bitty
dials, and there was a hose coming in from the private
sectors -MR. BERNANKE:
course.

We knew all those numbers, of

But a lot of smart people -- and you asked the

question about anticipation, people like Paul Volcker
and others thought it was going to cause a crisis.
they got it wrong.
dollar crash.

They thought it was going to cause a

It didn’t do that.

kind of crisis.

But

It caused a different

Just another example of how difficult

it is to predict.
COMMISSIONER GEORGIOU:

The dollar crash is

just slower or --

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MR. BERNANKE:

Well, it hasn’t happened yet,

but it didn’t happen in the early part of this decade.
COMMISSIONER GEORGIOU:
MR. BERNANKE:

Right.

Which is what Volcker at one

point said there was a 75 percent chance of a dollar
crash within two years, whatever.

So he’s been proven

wrong on that.
VICE CHAIRMAN THOMAS:

But that was the dials

that he had, in the structure that he was looking at.
MR. BERNANKE:

But essentially right.

The example I would give, would have been the
silo mentality of the regulators, that I’m looking at
this company, I don’t care about their counterparties,
I don’t care about the markets they’re involved in.

I’m

not thinking about -- there’s a difference between -if there’s a common risk -- if there’s a common exposure
across the whole system and that goes bad, that has a
much different implication than if it’s an uncorrelated
risk across the system.
But for an individual regulator looking at one
company, they don’t distinguish between those two, but

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it’s a critical distinction.

That’s why you need some

kind of interaction among the regulators.
VICE CHAIRMAN THOMAS:

Or a bigger,

comprehensive, more-umbrella regulatory structure.
MR. BERNANKE:

Right -- well, macroprudential.

VICE CHAIRMAN THOMAS:

Which one would you

prefer?
MR. BERNANKE:

I think you’ve got to be

careful not to create a situation where you’ve got
somebody -- something that’s so big and broad-picture
that it loses the confidence of the individual ability
to deal with individual -- because we have a very
complex system.
VICE CHAIRMAN THOMAS:
MR. BERNANKE:

Sure.

So I would prefer having a

systemic risk council which is responsible for the
overall system and looks for emerging risks and
coordinates and shares information, et cetera,
et cetera.

But underneath that, you’ve got specialists.
Think of them as divisions of the financial

services authority, if you wish, which do look at broad

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sectors, and then they talk to each other.
VICE CHAIRMAN THOMAS:

They talk to each

other?
CHAIR ANGELIDES:
one final question?

All right, why don’t we take

Because I know the Chairman does

have to depart at 2:30.
You would be the final questioner.
COMMISSIONER GRAHAM:
back to my employment question.

Well, I want to come
One of the criticisms

of the current banking system in many quarters is that
while we have been saving the banks by shoring up their
balance sheets, that we haven’t been creating incentives
for the banks to return to their traditional levels of
lending, particularly the smaller companies which are a
large employer.
A: do you think that is a legitimate
criticism?

And, B, if it is a legitimate criticism, are

there any steps that might be taken in a future crisis
to calibrate the policies to save the banks, to also
include some policies to save customers of the banks and
the employees of those customers?

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MR. BERNANKE:

So at my speech in New York

yesterday I talked about your two topics, unemployment
and small-business lending, which are both big problems.
COMMISSIONER GRAHAM:

Could I get a copy of

that?
MR. BERNANKE:

Yes, of course, we’ll provide

you with one.
So, of course, and again this is where the Fed
and the communication has failed, is that the public
still thinks that “Wall Street was bailed out.

We

weren’t bailed out.”
The reason we bailed out Wall Street -- I hate
that terminology -- but the reason we did it was to
avoid a collapse of the broad system, and so on.

So the

critical thing -- the first important achievement was to
prevent the meltdown of the global financial system,
which we did, in the fall and early into this year.
Given that we did that and the financial
markets are improving, the credit situation is, broadly
speaking, is improving slowly.

It’s still tough.

It’s

better, certainly, for larger firms than it is for

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smaller firms.
But let me make one observation from my own
experience, which is one of the things that my
historical studies has helped me with is, recognize the
politics is part of the dynamics of a financial crisis.
In the 1930s, after the crisis got bad, then they had
these Pecora hearings, where they were -- J.P. Morgan
got the -- the midget sat on his lap and all kinds of
funny things happened.

But it’s sort of predictable

that there’s going to be a political reaction.
been a very seriously political reaction.

There’s

And Sheila

Bair said yesterday that she thought that TARP was a
mistake completely because of the bad politics that have
come from it.
I don’t think that’s true because the
alternative would have been to let the system collapse,
which is not what we wanted to do.

But it’s true that

the politics have been bad.
And the reason why I’m raising this now is
that the original concept of the TARP -- not the
original-original -- but the one associated with the

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capital injections -- remember, there was a big program
called the CPP, the Capital Purchase Program, the point
of which was to put capital into otherwise healthy
banks.

Not to bail out banks or to save banks, but to

add capital to otherwise healthy banks.

And something

like $200 billion money was put out the door that way.
The reason for doing that, besides just generally
strengthening the system, was to give banks capital in
which to lend.
Unfortunately, the politics has been so
poisonous -- you know, both at the congressional level
but also at the local level, where people have accused
bankers of taking TARP money, of all kinds of horrible
things -- that the general response of bankers has been
to give the money back as fast as they can; or if they
have to keep it for some reason, not to base any lending
on it.
So, unfortunately, the second function of the
government capital, which was to provide a basis for
more lending, has become pretty much impossible because
of the political environment.

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CHAIR ANGELIDES:

Well, can I just challenge

that a little?
MR. BERNANKE:

Yes.

CHAIR ANGELIDES:
that observation?

On what basis do you make

As a practitioner of a real estate

market, I mean, the liquidity is extraordinarily
constrained.

But, I mean, on what basis do you say it’s

because of the poisonous political environment?
MR. BERNANKE:
reason -- I’m sorry.

Oh, that’s not the only

So -- he’s asking about policy

specifically.
So there are a lot of reasons why credit is
constrained.

Many of them have to do with just the

severity of the recession and the fact that the balance
sheets have been damaged and credit quality has worsened
and credit -- so we’ve done some studies at the Fed of
the determinants of the terms and conditions of lending.
And what we found is that, even given the depth of this
recession, banks have tightened their standards even
more than you would expect, given how bad the recession
is.

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So there’s a lot of things happening on the
supply side, including capital.
of things going on.

But there are a bunch

Banks are worried about what’s

going to happen to capital requirements in the future.
CHAIR ANGELIDES:
MR. BERNANKE:

Okay.

They don’t know -- they’re very

unsure about the speed of the recovery, and many other
things that are affecting that lending.

So I do need to

say -CHAIR ANGELIDES:

Yes, the only thing -- I’m

really focused on our mandate, which is examining the
cause to the crisis.

I just want to put a little point

in, that I’m not really sure that the absence of lending
is the result of popular anger over people losing jobs
and homes.
MR. BERNANKE:

No, no, no.

But I think one

factor -- one piece of policy was an attempt to try to
get banks to lend more by giving them more capital.
That part has not worked.
CHAIR ANGELIDES:
MR. BERNANKE:

I don’t disagree on that.

But I will say that there are

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other things, like the Fed’s TALF program -- actually,
in my defense, I should have mentioned a lot of the
other things we did to protect the asset-backed
securities market, the commercial paper market, money
market mutual funds, et cetera, et cetera, and our
monetary policy.
So there are improvements, and the supervisors
are working with the banks to improve that situation.
But there’s no magic bullet on that.
And the unique aspect of this crisis, which
was the capital injections, did stabilize the system.
And now, a great, good sign is that the banks are
raising large amounts of private capital and paying back
the government capital.

That’s a good sign.

But it was

not a particularly useful thing as far as stimulating
small bank lending, small business lending.
CHAIR ANGELIDES:

Terrific.

Thank you very

much.
Just a couple of things to close up here.
If we were to submit some written questions to
you, we would hope that you would respond to those.

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MR. BERNANKE:

We gave you a -- did we give

you the name of our contact person?
CHAIR ANGELIDES:
MR. BERNANKE:

William Nelson?

CHAIR ANGELIDES:
MR. BERNANKE:

Yes, William Nelson.

Bill R. Nelson.

CHAIR ANGELIDES:
MR. BERNANKE:

Yes, I believe we have --

Okay.

And we will provide you with

whatever you need.
CHAIR ANGELIDES:

Okay, terrific.

And then as you indicated when you first came
here, at some point I know we’d like to have you back,
perhaps both in private as well as public session, as we
do our work.
MR. BERNANKE:

Okay.

CHAIR ANGELIDES:

We’ll be mindful of all the

duties you have.
VICE CHAIRMAN THOMAS:

Do you have your

distribution list, whatever speeches you make, and you
send out in your normal network, are we on that list so
that we can get all your stuff?

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COMMISSIONER HENNESSEY:
MR. BERNANKE:
on the Web.

It’s on the Web.

It’s all on FederalReserve.gov

But we will –- what would you like?

CHAIR ANGELIDES:

We’ll go there.

COMMISSIONER HENNESSEY:
CHAIR ANGELIDES:
you so much, Mr. Chairman.
MR. BERNANKE:

It’s all there.

Thank you so much.

Thank

We appreciate your time.

Thank you.

(End of Closed Session with Mr. Bernanke.)
--o0o--

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