“That can’t be the answer,” Nason replied. “That would be a mess.”
“The problem is that half their book is the U.K.,” Macchiaroli said, explaining that many of Lehman’s trades went through its unit in London.
“And their counterparties are outside the United States, and we don’t have jurisdiction over them.” In the event of a disaster, all the SEC could do was try to maintain Lehman’s U.S. broker-dealer unit, but the holding company and all of its international subsidiaries would have to file for bankruptcy.
There were no good answers. Nason had raised the possibility that they might have no choice in an emergency but to go to Congress and seek permission to guarantee all of Lehman’s trades.
But as quickly as he raised the idea, he shot himself down.
“To guarantee all the obligations of the holding company, we would have to ask Congress to use taxpayer money to guarantee obligations that are outside the U.S.,” he announced to the room. “How the hell would we ask for that?”
Across a sweeping meadow from the Jackson Lake Lodge, the towering white peaks of the Tetons offered a majestic view, but one that no longer took Ben Bernanke’s breath away the way it once had. As he walked its trails on August 22 he recalled that it was here, at the Federal Reserve Bank of Kansas City’s summer symposium in the Grand Teton National Park, that he had first made his name nearly a decade ago. For the next three days, however, he could expect little more than criticism, questioning of his actions over the past year, and questions about what role the government should play with respect to Fannie and Freddie. In the summer of 1999, when the mania for Internet stocks was in full bloom, Bernanke and Mark Gertler, an economist at New York University, had presented a paper at Jackson Hole that contended that bubbles of that sort need not be a huge concern of the central bank. Pointing to steps taken by the Federal Reserve in the 1920s to pop a stock’s bubble that only created problems when an economic downturn took hold, Bernanke and Gertler argued that the central bank should restrict itself to its primary responsibility: trying to keep inflation stabilized. Rising asset prices should only be a concern for the Fed when they fed inflation. “A bubble, once ‘pricked,’ can easily degenerate into a panic,” they argued in a presentation that had been the talk of the conference and had attracted the favorable notice of Alan Greenspan.
A year ago Jackson Hole had been a more trying experience for Bernanke. As the credit crisis escalated that summer, Bernanke and a core group of advisers—Geithner; Warsh; Donald Kohn, the Fed vice chairman; Bill Dudley, the New York Fed’s markets desk chief; and Brian Madigan, director of the division of monetary affairs—huddled inside the Jackson Lake Lodge, trying to figure out how the Fed should respond to the credit crisis.
The group roughed out a two-pronged approach that some would later call “the Bernanke Doctrine.” The first part involved using the best-known weapon in the Fed’s arsenaclass="underline" cutting interest rates. To address the crisis of confidence in the markets, the policy makers wanted to offer support, but not at the expense of encouraging recklessness in the future. In his address at the 2007 conference, Bernanke had said, “It is not the responsibility of the Federal Reserve—nor would it be appropriate—to protect lenders and investors from the consequences of their financial decisions.” Yet his very next sentence—“But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy”—bolstered what had been perceived as the central bank’s policy since the hasty, Fed-organized, Wall Street-financed bailout of the hedge fund Long-Term Capital Management in 1998: If those consequences were serious enough to impact the entire financial system, the Fed might indeed have broader obligations that might require intervention. It was precisely this view that influenced his thinking in protecting Bear Stearns.
By this year’s conference the Bernanke Doctrine had come under attack. As Bernanke, looking exhausted, sat slumped at a long table in the lodge’s wood-paneled conference room, speaker after speaker stood up to criticize the Fed’s approach to the financial crisis as essentially ad hoc and ineffective, and as promoting moral hazard. Only Alan Blinder, once a Fed vice chairman and a former Princeton colleague of Bernanke’s, defended the Fed. Blinder told this tale:
One day a little Dutch boy was walking home when he noticed a small leak in the dike that protected the people in the surrounding town. He started to stick his finger in the hole. But then he remembered the moral hazard lesson he had learned in school… . “The companies that built this dike did a terrible job,” the boy said. “They don’t deserve a bailout, and doing so would just encourage more shoddy construction. Besides, the foolish people who live here should never have built their homes on a floodplain.” So the boy continued on his way home. Before he arrived, the dike burst and everyone for miles around drowned—including the little Dutch boy.
Perhaps you’ve heard the Fed’s alternative version of this story. In this kinder, gentler version, the little Dutch boy, somewhat desperate and worried about the horrors of the flood, stuck his finger in the dike and held it there until help arrived. It was painful and not guaranteed to work—and the little boy would rather have been doing other things. But he did it anyway. And all the people who lived behind the dike were saved from the error of their ways.
The previous day, Bernanke, in his address to the symposium, had made a plea to move beyond a finger-in-the-dike strategy by urging Congress to create a “statutory resolution regime for nonbanks.”
“A stronger infrastructure would help to reduce systemic risk,” Bernanke noted.
It would also mitigate moral hazard and the problem of “too big to fail” by reducing the range of circumstances in which systemic stability concerns might be expected by markets to prompt government intervention.
A statutory resolution regime for nonbanks, besides reducing uncertainty, would also limit moral hazard by allowing the government to resolve failing firms in a way that is orderly but also wipes out equity holders and haircuts some creditors, analogous to what happens when a commercial bank fails.
Bernanke did not mention Fannie or Freddie, but their fate was on the minds of many at Jackson Hole. That Friday Moody’s cut its ratings on the preferred shares of both companies to just below the level of non-investment grade, or junk. Expectations increased that Treasury would have to pull the trigger and put capital in Fannie and Freddie.
Jackson Hole also had, of course, long been a popular destination for the very wealthy. James Wolfensohn, the former Schroder’s and Salomon Brothers banker who became president of the World Bank, was one of Jackson Hole’s celebrity residents, and during the 2008 symposium he held a dinner at his home. In addition to Bernanke the guest list included two former Treasury officials, Larry Summers and Roger Altman, as well as Austan Goolsbee, an economic adviser to Barack Obama, who was about to be officially nominated as the Democratic candidate for president.
That night Wolfensohn posed two questions to his guests: Would the credit crisis be a chapter or a footnote in the history books? As he went around the table and surveyed opinions, everyone agreed that it would probably be a footnote.
Then, Wolfensohn asked: “Is it more likely that we’ll have another Great Depression? Or will it be more of a lost decade, like Japan’s?” The consensus answer among the dinner guests to that question was that the U.S. economy would probably have a prolonged, Japan-like slump. Bernanke, however, surprising the table, said that neither scenario was a real possibility. “We’ve learned so much from the Great Depression and Japan that we won’t have either,” he said assuredly.