I've been unimpressed with this oft-quoted bit from Phillip Swagel's insider account of the Paulson Treasury.

Legal constraints were omnipresent throughout the crisis, since Treasury and other government agencies such as the Federal Reserve must operate within existing legal authorities. Some steps that are attractive in principle turn out to be impractical in reality—with two key examples being the notion of forcing debt-for-equity swaps to address debt overhangs and forcing banks to accept government capital. These both run hard afoul of the constraint that there is no legal mechanism to make them happen. A lesson for academics is that any time the word "force" is used as a verb ("the policy should be to force banks to do X or Y"), the next sentence should set forth the section of the U.S. legal code that allows such a course of action—otherwise, the policy suggestion is of theoretical but not practical interest. Legal constraints bound in other ways as well, including with respect to modifications of loans.

Today's news (Clusterstock + source docs, WSJ Deal Journal, McArdle, Naked Capitalism, Calculated Risk, Marketwatch), that Henry Paulson, um, forced Bank of America's near suicidal merger with Merill Lynch kind of clinches the case. Pre-Merrill, BOA was viewed as relatively healthy among large banks. What's the statute under which a Treasury secretary unilaterally fires and replaces the board of a healthy bank? The Paulson Treasury talked up legal constraints whenever they were faced with something Paulson didn't want to do. When Paulson, or Bernanke, really did want to do something, they were very creative about bending the law to their will. The Fed's "special purpose vehicles" are clearly not lending in the sense that the architects of the Federal Reserve Acts "unusual and exigent circumstances" clause foresaw. The FDIC has no statutory authority to issue ad hoc guarantees of bank debt, but flexibility was read into the laws.

With respect to the banks, the Paulson Treasury could have forced any big bank into a bail-out or receivership scenario just by looking at it funny, or by having the Fed take a conservative view of bank asset collateral values under the special liquidity programs. It's worth noting that Treasury very ostentatiously forced banks to accept TARP capital, and Geithner's Treasury was able to persuade holders of Citi preferred to convert to common equity.

It's not exactly right to say that our don't-ask-don't-tell quasinationalization policy has given us "ownership but not control". An assertive Treasury secretary has tremendous leverage over zombie bank managers. Instead, what we have is is control without accountability. An informal, unauditable, hydra-headed set of private managers and public officials controls how quasinationalized banks behave. Neither taxpayers nor shareholders have reason to believe that decisions are being taken in their interest. The informality and disunity of control impedes the kind of hands-on, detail-oriented supervision and risk management that ought to be the core preoccupation of bank managers. Exactly as opponents of nationalization feared, America's large banks are poorly run behemoths that routinely make idiotic commercial decisions to satisfy tacit political mandates. No one really knows who is responsible for what.

Ironically, there might be less scope for political control if banks were in formal, least-cost-resolution receivership. A bank that has already failed cannot fail. If independent boards are appointed to oversee the receiverships, politicians might have very little leverage. Incumbent private managers face collapse, sacking, disgrace, and potential civil and criminal liability for improprieties that come to light during the post-mortem. New moderately paid, high reputation board members would bear no responsibility for what came before, and could very publicly resign in protest if pushed to act in a manner inconsistent with their charter. (Resignation in protest by long-affiliated board members of a zombie bank would have different reputational consequences, and it would be difficult to recruit high-reputation outsiders to serve on zombie bank boards.) Promoting insiders or recalling retired executives to run zombie firms leaves the leadership weak and compromised. A much higher caliber of outside talent could be recruited to oversee banks in receivership than would accept responsibility for banks that are insolvent but on government life support.

This is not to say that formal public control would be a panacea. The list of public and quasipublic organizations currently being gutted by politically motivated credit expansion includes Fannie Mae, Freddie Mac, FHA, FHLB, FDIC, and the Federal Reserve system. A bank in receivership managed by a weak board or not institutionally segregated from political bodies could easily join the list. But if received banks were put under strong boards, and given clear mandates to divide and sell their assets (maximizing taxpayer value subject to a scale constraint) while running off their lending books, there would be little hazard of politically directed credit or other shenanigans. That would imply that large insolvent banks would reduce their lending, contradicting the Administration's endless exhortations that banks should lend, lend, lend. My view is that public encouragement of expanding indebtedness is very bad policy (read Finem Respice). But if you misguidedly believe that "credit is the lifeblood of a modern economy", the thousands of well-run smaller banks in America are fully capable of taking advantage of today's deeply subsidized lending spreads to serve creditworthy borrowers. Whether in private or in public hands, the big, broken banks are simply too compromised to lend.

Steve Randy Waldman — Friday April 24, 2009 at 1:53am permalink
raivo pommer-eesti (mail):

The contraction followed a 1.6 per cent slump in the last three months of 2008 - the first time two successive quarters have contracted more than 1 per cent since records began in 1948.

Today's estimated fall in quarter-on-quarter output is the largest decrease since 1979, according to the Office of National Statistics (ONS).

The news came as official figures also showed that car and commercial vehicle (CV) production fell sharply again last month (see below).

The dire figures come after Chancellor Alistair Darling indicated a 1.6 per cent slump in the quarter by saying the contraction would be similar to the previous period in his Budget speech.

He also predicted the economy would shrink by 3.5 per cent this year - more than double his previous forecast.

Today's figures come amid savage declines in output for many key sectors of the economy.

Much of the contraction was driven by an acceleration in decline for the service sector, which fell 1.2 per cent from a drop of 0.8 per cent the previous quarter.

Services, which account for 75 per cent of the UK's economy, were pushed lower by a significant drop in business services, according to the ONS.

Business services, including accounting and legal services, slumped 1.8 per cent, the largest fall since records began in 1983.

Total production - including manufacturing, mining and electricity, gas and water supply - declined by 5.5 per cent, the biggest fall since 1974.
4.24.2009 8:15am
Fernando (mail):
>What's the statute under which a Treasury secretary unilaterally fires and replaces the board of a healthy bank?

The federal reserve has this authority, in fact it ROUTINELY reached agreements with bank management for them to step down or face criminal prosecution, in fact just yesterday they did with two banks I believe. If Lewis threated the stability of the banking system with his actions then the fed in fact HAD a legal right to ban him from banking since he would have acted in a way that would be inconsistent with the fed's mission of oversight and stability of US banking
4.24.2009 8:27am
beezer (mail) (www):
I still maintain a national bank formed by the takeover of, for example, Citi would be beneficial. Using the existing Citi infrastructure, the national bank could accomodate lending needs nicely. They could lend to their own clients, and as a national bank, process money to other banks for their client needs--supplementing the local bank's ability to lend. And they could do so at a low cost with existing personnel.

Without the national bank, Treasury and the Fed have relatively ham handed ability to be conduits to lending that furthers public policy.

Just saying.
4.24.2009 8:44am
Independent Accountant (mail) (www):
Neither the Fed nor the Treasury has the authority to suspend the securities laws. Bernanke and Paulson should both be indicted for aiding and abetting securities fraud. Lewis is a gutless wonder. He should have "blown the whistle" on the dynamic duo with a press conference. Fernando has no concept of law. Which makes sense as the US becomes a banana republic.
4.24.2009 9:24am
Fernando (mail):
Just to show how wrong you are Steve,
take a look at the 2009 enforcement actions from the Fed
Fed Enforcement

firing management, demanding dividend cuts, banning people from banking is what the fed does routinely.There is nothing wrong illegal about this, if Lewis lack of due dillegence threated another Lehman meltdown then he should have been banned from banking. The problem here is encouraging securities fraud, not abuse of power
4.24.2009 9:29am
Steve Randy Waldman (mail) (www):
Fernando — No offense, but I'm not wrong.

Bank regulators have extraordinary authority over the officers of an unhealthy bank. But, if it is the case that a bank is healthy, regulators have no legal ability whatsoever to fire, ban, demand dividend cuts, etc.

If the Fed/Treasury knew that Bank of America was weak and in need of prompt corrective action prior to its merger with Merrill, then it would have a great deal of authority, although the manner in which it proposed to exercise its authority -- unilateral sacking of the CEO and board rather than a negotiated agreement -- would have been unusually extreme.

But the Fed/Treasury was claiming that BOA was in fact a strong bank. It was that very strength that enabled it to be so helpful by merging with Lehman. Regulators have no authority whatsoever to compel a strong bank to act or not act for systemic reasons. "Not exercising due diligence" is odd grounds for compulsion here. After all, BOA did ensure there was a MAC clause in its merger agreement, and would have had full ability to use it as it learned Merill's true state had authorities not intervened.
4.24.2009 10:15am
This entire incident makes me question the concept of "regulatory capture" being bandied about so freely these days. "Regulatory capture" conjures up a scenario where the banker says "jump" and the regulator asks "how high?" Is this not evidence that the situation is more nuanced than that?

Bernanke, Paulson and Lewis chose to live in a Twilight Zone that exists outside of the normal universe of legal, moral and ethical restraints that most of the rest of us live within. In this netherworld, the role of bankers of Lewis' ilk is to loot, through practices that are unethical and/or illegal, the world of as much money as he possibly can. The role of government authorities like Benanke and Paulson is to look the other way. Given the revolving door that exists between Washington and Wall Street, all were, or at least could look forward to being, very handsomely remunerated.

Does the distinction between banker and regulator even exist in this surreal world of immorality and/or illegality inhabited by Bernanke, Paulson and Lewis? It seems to be somewhat of a false dichotomy.

This incident, nevertheless, shows us where the true power really resides. As the spotlight begins to shine on these cockroaches, those currently with regulator status can decide not to look the other way. And if you're like Lewis, your entire business plan being dependent on regulators looking the other way, this makes you very vulnerable. And certainly Paulson and Bernanke, who have spent years looking the other way, must know where many bodies are buried.

Paulson and Bernanke, however, are not without their own vulnerabilities. They are public servants and therefore have greater responsibility and accountability to the public. And guys like Lewis surely know where some bodies are burried too.

But Paulson and Bernanke have one very good thing going for them. And that is that Lewis can't point the finger at them without also pointing the finger at himself.
4.24.2009 12:04pm
Fernando (mail):
>Regulators have no authority whatsoever to compel a strong >bank to act or not act for systemic reasons

The Fed has a duty to oversee the banking system, if a CEO is acting in a way the threatens the stability of that system its reasonable to them to remove them from banking. The time for Lewis to get cold feet was in september, MER had STAGGERING LOSSES during the year, it is really resonable to expect everything would be fine and rosy from them on?

If the regulator of a nuclear power plant sees the management transporting uranium in a way that might create a nuclear explosion but its not illegal according to current law the regulator has a DUTY to stop that behavior. To argue otherwise is to say they should oversee the destruction of the state they are in with crossed arms in order to behave according to some utopian 'moral' principle
4.24.2009 12:09pm
Fernando (mail):
Further more the gov has reimbursed BAC shareholders through cheap guarantees. So the damaged has be repaired, if you really think the regulators and government cant behave in ways that would not be conventional even in emergencies, I supposed you dont think its right for the US President to lie and commit fraud to the public to prevent a nuclear war, so therefore you put the very EXISTENCE OF THE EARTH before following rules and honesty, which is a immoral and wrong position in itself
4.24.2009 12:19pm
Fernando (mail):
What I meant by the last comment is that existence of earth is more important the following the rules, so the US president has the right to lie and defraud the public if he is very sure it would prevent a nuclear war
4.24.2009 12:21pm
Fernando (mail):
If Ken Lewis decided to ignore the banking system stability even though the government would reimburse him for losses then he is a reckless banker(who behaves against his own self-interest since a MER bk would he noone) and the fed has the right to remove him from banking. It doesnt matter what his current capital ratio is
4.24.2009 12:49pm
Steve Randy Waldman (mail) (www):
Fernando — I think we're not really disagreeing any more. My only point is that ordering a healthy bank to take a bet-the-company kind of strategic decision, at pain of firing the CEO and board is very unusual and not foreseen by banking regulations.

I quite agree with you, that at least how Bernanke and Paulson saw things, extraordinary measures were justified and so they chose to interpret their powers liberally. It's analogous to the "ticking time bomb" scenario often used in torture debates. Sometimes it is arguably right to do what would not normally be legal, given a totality of circumstances. Of course, the problem in both contexts is that once you accept that as a general principle, the line between when things are extreme enough to bend rules and when the costs of nitpicking bureaucrats are worth tolerating becomes blurred, and powerful actors are likely to cut Gordian knots too frequently.

But fundamentally I think we're on the same page — I don't deny that Paulson and Bernanke thought their extraordinary threat justified here. But that they could credibly make it, irrespective of the justification, implies that they have a great deal more power over how especially large banks behave than someone like Swagel suggests. And since this power is largely informal, it may not be as accountable as we (or the shareholders of BAC) might like.

BTW the ex-post "reimbursal" with guarantees is an interesting wrinkle, but it adds to the unaccountability story. This was a bet the company deal for BAC and its shareholders that was compelled without public disclosure. It was also a potentially costly deal for US taxpayers, arranged informally and on an emergency basis without any taxpayer or Congressional input. That this "value for value" exchange was arranged in undocumented telephone conversations while Paulson was on a bicycle, with an explicit proviso that a more formal venue would lead to a less favorable arrangement because the forces of accountability would demand more caution, is quite extraordinary.
4.24.2009 4:15pm
absolutideas (mail) (www):
nice site, check out mine too. I have found you on abnormal returns.
4.24.2009 5:57pm
Fernando (mail):
I agree. In fact I would go as far to say that Paulson deserves credit for doing what he did, he put the country first. We hear him get ripped apart for 'letting lehman fail' when he had no TARP authority to save them(except the currency stabilization fund which would demand him to lie and say LEH could affect the dollar in a big way), then the same people rip him apart for saving MER by encouring securities fraud and threatening ken lewis. Just which one is it, should he lie and do whatever is necessary to save the system or should follow the law and let things breakdown?
4.24.2009 6:06pm
TA (mail):
Having read the Finem Respice link (which captures my feelings nicely) and sampled the borderline fascistic instincts of some of the commenters to this post, I'm going to buy a gun.
4.24.2009 9:28pm
Steve Randy Waldman (mail) (www):
Fernando — Paulson definitely took risks, as has Bernanke. Whether you view them as heroes or villains has a lot to do with whether you think their overall approach is right. If collapse of the BAC/MER deal would have been a national or even global catastrophe, then the risks they took (which could come back to harm them personally) were heroic. I'm sure that's how they see things.

But if in fact they are erring, if the approach they are taking is not the best approach (as I and other malcontents believe), their constant bending of the rules that are intended to direct and constrain them look like an abuse of power, and their ability to take those risks, however well-meaning they may be in doing so, looks like a hazard and a problem.

Time may tell whether they are villains or heroes. Or it may not, and we may disagree forever, as we won't ever know what would have happened had they not strayed from the bounds of preexisting norms...
4.24.2009 10:04pm
MarketBlogic (mail) (www):

Clearly the entire sleazy BofA, Merrill, Treasury, Fed, Lewis, Thain, Paulson and Bernanke mess stinks to high heaven, but did you see Luskin's angle on Cuomo's supposed "smoking gun" letter to Congress:

"Cuomo writes that according to a deposition by CEO Lewis, “Bank of America did not disclose Merrill Lynch's devastating losses . . . and would have done so but for the intervention of the Treasury Department and the Federal Reserve.”

In Lewis's own words from the deposition, he “was instructed that ‘We do not want a public disclosure.'” Cuomo's office asked, “Who said that to you?” And Lewis responded, “Paulson.” On the face of it, that would seem like a smoking gun — placed in Lewis's innocent hand by the secretary of the Treasury of the United States of America.

Is that the “public corruption” Barofsky is talking about?

Maybe. But then again, maybe not. In his letter, Cuomo goes on to say that “Secretary Paulson … informed this Office that his discussions with Lewis regarding disclosure concerned the Treasury Department's own disclosure obligations” with respect to the commitment of future TARP aid — not the matter of Merrill's loss.

Indeed, this very distinction is made by Lewis himself in the same deposition. Lewis was asked, “A public disclosure of what?” He responded, “Of what they were going to be doing for us until it was completed” — that is, the TARP commitment. Lewis was then asked specifically, “How about of Merrill fourth-quarter losses?” His response: “That wasn't an issue that was being exchanged.”

It would appear that Cuomo may have significantly misrepresented Lewis's testimony by claiming that he “would have” disclosed the Merrill loss “but for the intervention of the Treasury Department,” since by Lewis's own testimony the Treasury's intervention wasn't even on this subject. And Cuomo appears to mislead Congress when he says that Paulson “informed this office” — as though by way of clearing himself of culpability — of the very thing that Lewis himself already said."

I'm not about to defend anybody in this thing (including Cuomo!), and I think it's very clear that the Treasury under Paulson was bullying major banks extra-legally from at least Sept 15th 2008 forward. THAT SAID, I'm not yet convinced that Ken Lewis actually said under oath what Cuomo's letter alleges that Lewis testified to. So it's a pretty odd situation - Ken Lewis didn't state specifically that BofA would have disclosed Merrill's trading losses if the Treasury hadn't pressured them not to, even though that's true - those seem to be words put in Lewis' mouth by Cuomo . . . . . . .

At this point, I'd like to see them all put in jail for several decades - we can start with Chuck Prince, Ken Lewis, John Thain and Dick Fuld - but the Lewis testimony doesn't look to me like quite all that it's been cracked up to be by Mr. Cuomo, and NO I would not buy a used car from that man, nor Elliot Spitzer nor Ben Bernanke either.
4.24.2009 10:11pm
Steve Randy Waldman (mail) (www):
MarketBlogic — Interesting point. I was more shocked by the firing-the-board threat than the failing-to-disclose, but regarding that, there's certainly been a widespread perception that Treasury gagged BAC on losses. If the issue was disclosure of the quid pro quo, the terms of which we know Treasury didn't want to put in writing, that's still bad — it would be material to shareholders — but nondisclosure would be more justifiable than not disclosing the trading losses, since the unwritten commitment was arguably too contingent and uncertain to create an obligation to disclose (and would have been put in jeopardy, to the detriment of shareholders, by an unauthorized disclosure).
4.25.2009 5:11am
raivo pommer-eesti (mail):
raivo pommer-www.google.ee



The International Monetary Fund's (IMF) managing director has said the US and Western Europe need to act more quickly to sort out their banking systems.

Speaking in Washington before a series of high-level financial meetings, Dominique Strauss-Kahn said there had been progress but it had been too slow.

Mr Strauss-Kahn said cleaning up the mess in the financial systems of the rich world was the most important task.

But more action was needed to sort out problems with bad loans, he said.

He accepts that there has been progress. But he says it is not enough.

"In many countries the architecture of a coherent financial programme is now more or less in place. What is lagging, and where time has been lost, is in the implementation," he said.

His call was directed mainly at the United States and Western European countries.

Sorting out the banks was essential he said, if there is to be an economic recovery.

"All the experience we have of past banking crises, and we have a lot of experience with those banking crises in this institution, is that you never recover before you have completed the cleaning up of the balance sheet of the financial sector," he said.

Mr Strauss-Kahn will have an opportunity to press finance ministers on that over the next few days at a series of meetings in Washington.

In one area, he said was pleased with progress.

The stimulus from governments in tax cuts and extra spending for this year, Mr Strauss-Kahn said, is in line with what the IMF called for, though he suggested more might be needed in 2010.
4.25.2009 7:15am
joebhed (mail):
Gee, Steve, every once in a while I see an opening for the grand lesson of America's monetary history, which is, it's OUR money system, but it fades into the personalities and interests of the major players.

Just try this for a second, please.

We are a sovereign people and a sovereign country has the absolute right to fully control every aspect of the money and banking systems in that sovereign country.
Viz - the Revolution.

If the banks can tell the government how their money monopoly is going to act with the money they control, and they control ALL of it, regardless of whether the government believes that these actions are not in the best interest of the country, the economy and the people,then the people do not control the money system.

For some reason, the vast financial and economic intelligencia out there are totally incapable of distinguishing between the private banking system and the present "debt-money" system of the Federal Reserve.

We need a vibrant private banking system.

We also need a new system for creation of the nation's money, debt-free, trickle-up, which has nothing to do with banking.

The Chicago Plan. Take a look.
4.25.2009 9:17pm
Taunter (mail) (www):
The crucial problem for me in the entire BAC/MER drama is that all parties seemed to believe an outcome whereby the US taxpayer subsidized BAC to buy MER was a perfectly normal and just arrangement.

If Paulson believed that MER's failure would bring on the fall of the empire, he should have told Lewis to go ahead and invoke the MAC if Lewis saw fit and then bought MER directly. This way we could have had a serious, open debate about whether it made sense to subsidize MER shareholders and transfer MER debt at par or whether MER's condition required impairment to its capital structure.

For different reasons, however, each of the parties thought the best answer was to flat-out lie, and figured that if the consequence of this strategy was losses to the US taxpayer, well, so be it.
4.27.2009 2:11pm
Steve Randy Waldman (mail) (www):
Taunter — Excellent. How strange it ought to seem that our political and economic system is one in which the idea of not employing and succumbing to constant misdirect is considered both dangerous and naive. How sad that it does not seem strange, that we are fish swimming in water.
4.27.2009 8:14pm
How I Lost Thirty Pounds in Thirty Days (mail) (www):
Hi, nice post. I have been thinking about this topic,so thanks for sharing. I'll certainly be coming back to your posts.
5.3.2009 5:19pm
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