Before looking at how the Committee to Save the Banks reacted to the acute phase of the financial crisis in 2008, it is necessary to look at the members of this committee (Paulson, Bernanke and Geithner).

Let’s look at how they saw themselves through their own eyes as they explained in their interview with Kai Ryssdal:

Bernanke: Well, I was of course, you know, reluctant to invoke powers that hadn’t been used for many years, and I was worried about the political backlash, the effects on the Federal Reserve. But it was a decision the three of us made, and I felt very comfortable with the decision that if Bear Stearns had failed in a uncontrolled way that it would have reverberated throughout the financial system, caused a lot of damage and probably brought the financial crisis forward by at least six months.

Ryssdal: I wonder whether you would agree with this statement, all three of you, that Bear Stearns was the moment people really started paying attention. You guys had been living with this for a long time, 18 months, two years, knowing. All of you say in your books you knew it was coming. Do you think people really, it focused people’s minds, Hank?

Paulson: Well, it I think focused the public’s mind in a big way. There had been a lot of focus in the markets. And I want to come back to what Ben said, because I believe in many ways, this was one of the most impactful things that we did together, and it was interesting, because the three of us come from different political parties, different backgrounds. You know, Ben had been, you know, just a world-class economist, studied the Great Depression. Tim had worked in the in the Rubin Treasury, had a lot of experience working through a crisis. Before, I’d come from Wall Street. But none of us debated at any length as to whether it would be a big problem if Bear Stearns had failed. We all knew that.  [emphasis added]

Bernanke introduces himself as a man lacking both leadership and courage.  Despite knowing what was coming for 18 to 24 months, he couldn’t take any action or get the Fed to take any action to prevent the acute phase of the crisis.  And when the acute phase started, he needed others to help him make the decision to use the Fed’s powers to prevent an uncontrolled collapse of Bear Stearns.

Paulson introduces himself as the puppet master with Bernanke and Geithner dancing as he pulls the strings.  Notice how he calls Bernanke a world-class economist.  Sounds great until you realize the economics profession failed to see the financial crisis coming.  Suddenly, being a world-class economist is the equivalent of walking over a bar buried 6 feet underground.

Paulson observed Bernanke studied the Great Depression.  Flattery as Bernanke likes to call himself a Great Depression scholar.  There is only one problem with Bernanke’s claim.  He was a scholar of the Great Depression who couldn’t bring himself to study how the policymakers had redesigned the financial system in response to the Crash of ’29 and the Great Depression.  When I wrote Transparency Games, I used Amazon’s word search function to look up keywords/phrases in Bernanke’s book (collection of essays actually) on the Great Depression.  I searched on words and phrases related to the 1930s redesign like transparency, opacity and even the SEC.  Unlike Federal Reserve and monetary policy, the words/phrases related to the redesign either didn’t appear or were used only a couple of times.  Even when these words/phrases were used they were never used in the context of the redesign of the financial system.  Bernanke had managed to study the Great Depression and missed the redesign of the financial system.

Paulson puffs up Geithner as experienced at handling financial crises.

Paulson demonstrated his complete control over the Committee to Save the Banks when he observed there was no debate over whether or not it would be a big problem if Bear Stearns failed in an uncontrolled way.  The committee members knew it would be.

How did they know this?

Because of something they learned from their peak inside and handling of two other large, opaque financial institutions:  Fannie and Freddie.

Paulson: Then what happened was the Fed got in and took a look at them. We had Morgan Stanley come in and take a look. We got all the information we needed. We learned, holy cow, the problem is much worse than we thought it is. There is a big hole, and on top of that, their regulator had very recently asserted that they were well capitalized. [emphasis added]

Let me see if I understand this correctly.  In order to determine the financial condition of Fannie and Freddie, the Fed and a Wall Street firm couldn’t just look at publicly disclosed information.  Rather, they had to looked at information these companies had that was not available to other market participants.  This undisclosed information just happened to be what was necessary for determining if Fannie and Freddie were a) solvent and b) viable. [Paulson’s statement makes one positive contribution. It makes the case for the Transparency Label Initiative as clearly the publicly disclosed was insufficient.]

What they found with this undisclosed information was the problems at Fannie and Freddie were worse than they thought before going in.  And perhaps even more significantly, Fannie and Freddie’s regulators told market participants these entities were well capitalized (please note the irony here as the Fed has been saying this since it began stress testing the banks in 2009).

Is there any reason to think other market participants understood how bad the problems were at Fannie and Freddie?  No!

I’ll leave it to Geithner to summarize the position the Committee found itself in:

Geithner: I mean another thing about these, about runs like this is to stop a panic, protect people from a panic, you have to have, be able to deploy a level of force that is dramatically large relative to the problem so you can reassure people that if they stay and don’t run they’ll be safe and that kind of thing…. [emphasis added]

Recall how Paulson wanted a bazooka to deal with the problems at Fannie and Freddie.

The enemy was the fear and the loss of confidence and the sense of no bottom, no foundation, and the enemy was the perception that the safest thing you could do as a depositor in a bank or as a lender to somebody or as a businessman or something that, is to rush for the exits to protect yourself against the harm to come. [emphasis added]

This sounds exactly like my description of what happens when the valuation story for opaque securities in the Blind Betting quadrant of the Information Matrix is called into doubt.

And the collective that’s maybe rational individually, but the way panics work is the collective damage that rational behavior causes is the deep existential threat to the country. And so the scary thing is to figure out how you break that spiral, how you can alter the incentives, how you convince people that we can put a floor under things, it won’t erode beneath them, we can pull the thing back from the abyss so they can get back to the business of, you know, trying to make their business work and hire people. [emphasis added]

If Bernanke had spent any time studying how the financial system was redesigned in the 1930s, he would have known it wasn’t hard to break the spiral and put a floor under things.  You see, not only did policymakers redesign the financial system in the 1930s, but they used the redesign to break the spiral of bank runs and put a floor under things.

Perhaps most importantly, policymakers in the 1930s didn’t try to convince people they had pulled “the thing back from the abyss”.  Rather, they recognized transparency offered a “level of force that is dramatically large relative to the problem”.  Transparency allows everyone to see for themselves where the bottom is and when the problems have been addressed.

Transparency is the ultimate source of confidence in the global financial system and economy.  When people have access to the necessary information, they trust their own analysis and this trust is reflected in confidence in the financial system and the economy.

Of course, resorting to transparency was not an option Paulson could permit.  Doing so would have dramatically shrunk Goldman Sachs and Wall Street.  It would have lead to holding bankers responsible for their misbehavior behind a veil of opacity.

Paulson needed Bernanke and Geithner to ignore the obvious need for bringing transparency to the opaque corners of the global financial system and instead pursue a different response to the financial crisis.

Paulson:  During a crisis, what happens is the market gets very quickly to where the most panicked investor gets. And so a good example, so Fannie and Freddie, there was a short time there where I sat in my office, looked out at the Washington Monument, and my eyes actually moistened, and I said, “We may have put out this fire. You know, this may have been the dynamite we needed.” I mean, what a strong statement, coming in, nationalizing Fannie and Freddie, mortgages are ground zero of, you know, the crisis, government stands behind it, help all the financial institutions. The market instead looked at it and said, “Holy cow, if Fannie or Freddie has got all those bad mortgages, just think how bad Lehman might be.” [emphasis added]

Or Goldman or JP Morgan or ….

And so it, that’s just what happens with these things sometimes, the things you’re doing that you think are going to knock it out, you just even accelerate it. [emphasis added]

When the things financial regulators are doing don’t include providing transparency, there is no reason to think the financial regulators aren’t making the situation worse.  After all, the market is very good at asking why won’t the financial regulators provide transparency so it can independently confirm the regulators have addressed the problem.

Asking the market to “trust” you without any ability to verify your story is a very Wall Street solution.

Unfortunately, the credibility of all the financial regulators was undermined when the regulator overseeing Fannie and Freddie declared they were well capitalized.  Oops.

Showing the skills that lead him to the top of Goldman, Paulson didn’t miss a beat.  He had an ace in the hole to keep the bailout dollars flowing and opacity firmly in place.

Paulson:  So let’s take Fannie and Freddie. So it illustrates two things. First of all, Ben is being modest. So you have — it’s very unusual, I think, that we had a chairman of the Fed that had the political skills that Ben had and the courage that he had. Because when I was up there working to get the authorities from Congress, there was no way we had any chance of getting them, in my judgment, if Ben hadn’t been right up there, two of us together. [emphasis added]

Who can forget the look on Bernanke’s face during the Congressional hearing asking for money to bailout the banks?  It was not the look of a courageous man.  It was the look of a panic stricken desperate man.

Why would Bernanke have that look?  Because even as the Fed Chairman he discovered he share something with the market:

We didn’t have all of the information we needed. [emphasis added]

As a result, he was the most panicky investor and had visions of a second Great Depression.  Visions Paulson did nothing to stop.  Visions any Great Depression scholar should have known were unwarranted.

Why?

Remember those 1930s policymakers.  They redesigned the financial system so it could never happen again.  With deposit insurance and the Fed acting as a lender of last resort, they assured the banking system could continue to function and support the real economy even if the banks were all insolvent.  A fact Bernanke missed as a young Economist when he wrote:

I’ve done a lot of work on the Great Depression of the 1930s, and one of my very first papers as a young academic argued that one of the reasons the Depression was so deep and so long was because the financial system collapsed, the banks closed, banks are closed or alternatively almost near failure. They can’t lend.

Of course, Bernanke couldn’t be expected to know anything about the Savings and Loan Crisis in the 1980s.  It showed the redesign of the financial system worked.  Insolvent Savings and Loans continued to lend for several years before the government systematically closed them down.

A decade after the acute phase of the Great Financial Crisis, Nobel prize winning Economist Paul Krugman stumbled upon something else these policymakers did a Great Depression Scholar should have known about.  They adopted automatic stabilizer programs that were expanded in the 1960s.  These programs kicked in when the recession started and prevented the recession from becoming more severe.

If the banks were all insolvent, there would have been a significant clean-up task.  As shown by Iceland, this could have been done quickly.  All of the bad debt in the financial system could have been written down to the higher of what a borrow can afford to repay or a third party would pay for the collateral.

With this done, each financial institution could then be looked at to see if it was still viable.  If it was, it could continue and retain all pre-banker bonus earnings to rebuild its book capital.  If it wasn’t, it would be closed down and its good assets “sold” to a new firm.

Finally, like the Savings and Loan Crisis, government lawyers could have pursued bankers for any misbehavior like rigging financial markets they engaged in.

Instead, Paulson prevailed and the Committee to Save the Banks chose saving Wall Street over using the financial system as it is designed to handle a financial crisis.

Next: Part IV Defending the Indefensible