This may well be one of the most important articles we have run on this blog in some time. In this article we feature an article written by Mike Silva. Mr. Silva served as the Chief of Staff for Tim Geitner at the NY Fed and stayed on at the NY Fed under new President Bill Dudley when Tim Geitner moved on to become Secretary of the Treasury.
In this position, Mr. Silva had a front row seat during the most recent financial crisis in 2008-2009. Most of us suspected the entire financial system was closer to implosion that we realized at that time and Mr. Silva confirms that to be true in this article. He goes on to explain how and why certain actions were taken to prevent total systemic collapse. In the conclusion to his article he states very clearly that he believes we will have another major financial crisis “sooner rather than later”. Given his insider position, this is clearly an article we all need to read and understand. Below are a few excerpts and then a few added comments.
“During the financial crisis, I served as Tim Geithner’s chief of staff at the New York Fed and, then when Tim became Secretary of the Treasury, I served as chief of staff for the next president, Bill Dudley. My role allowed me to directly observe an impossibly small number of Americans at the New York Fed, the Board of Governors of the Federal Reserve and the Treasury Department fight desperately to save the financial future of all Americans. Thank you for this opportunity to tell their story.”
“On the night of Thursday, 13 March 2008, I was one of a small group of NY Fed officials huddled in Tim Geithner’s office, listening as several senior SEC officials reported that the investment bank Bear Stearns would not be able to open in the morning.”
. . .
“As an investment bank, Bear was part of the ‘shadow banking system’ that was completely outside of the Fed’s jurisdiction and not subject to any kind of ‘prudential supervision’ (i.e. supervision to ensure that it was being run in a safe and sound manner). We had no direct insight into Bear. In fact, some of us did not even know where it was located.”
. . . .
“At this point, Tim and Chairman Bernanke started discussing the possibility of invoking the Fed’s emergency lending authority under Section 13(3) of the Federal Reserve Act to lend to a non-bank. Under Section 13(3), the Fed could lend to a non-bank if it determined that “unusual and exigent circumstances” existed and it was “secured to its satisfaction”.
Fortunately, our examiners determined that Bear had sufficient collateral for us to be “secured to our satisfaction”. Now, the question became whether “unusual and exigent circumstances” existed. Tim felt that they did. Bear was not a particularly large institution, but it was a highly interconnected one. Its failure could easily result in enough cover selling and collateral calls to trigger a negative asset spiral.”
Editors note: The article goes on to explain how Lehman Brothers would later fail and why the Fed could not bail out that firm legally. Then things got worse as the crisis spread as described below in the article.
. . . “Consequently, on the morning of Monday, 15 September, Lehman declared bankruptcy.”
“The markets that Monday were ugly. At one point, the NYSE was down 1,000 points, which was a lot back then. However, stocks rebounded and ultimately closed down 500 points. That was bad, but not a meltdown. Importantly, much of the decline was attributable to rumors that AIG was also in trouble. But we already knew about AIG and it was a much easier case for two reasons.”
. . . .
“On Tuesday, 16 September, word came that a $65 billion money market fund called the Primary Reserve Fund had bought $785 million of Lehman commercial paper, betting that the Fed would bail out Lehman. It bet wrong and that paper became worthless. As a result, the fund was not able to repay $1 for every $1 invested and it “broke the buck”. Investors in the fund did not react well to that. Within 24 hours, they had withdrawn almost two-thirds of their money.
Much worse, investors not only began withdrawing funds from money market funds with exposure to the financial system, they began withdrawing money from ALL money market funds.
Money market funds are among the largest purchasers of commercial paper (CP) and CP is how corporate America funds itself. CP is how Boeing, Caterpillar, Microsoft and General Electric meet payroll and pay suppliers. Suddenly, a crisis that had been limited to the financial system had jumped the tracks into the real economy. Over the next 10 days, lending of all types ground to a halt. Complete panic had set in.
This was a terrifying moment. Central banks know how to support individual institutions, but no central bank had ever tried to support entire markets. And that was what we had to find a way to do.”
Editors note: The article next explains all the massive intervention undertaken by the Fed to stave off the crisis from spiraling into a complete depression. It’s clear that we were much closer to this situation than most people understand as the crisis was unfolding at that time. In the conclusion, Mr. Silva lists some lessons learned and then makes a prediction for the future. Below is one “lesson learned” that caught my attention and then his prediction. I added the underliines for additional emphasis.
RATIONAL BEHAVIOUR IS OVERRATED (Lesson Learned #2)
“A lot of economic, market and bank supervisory theory is based on the premise that financial actors are largely rational. The crisis convinced me that they are not. It was not rational for very experienced financial leaders to make their companies hostage to short-term financing that was, in the final analysis, secured by the irrational assumption that house prices will always go up. It was not rational for Dick Fuld to reject offers because their terms offended his pride. It was not rational for money market fund investors to flee all money market funds just because one fund made a bad bet. It was not rational for some lenders, at the height of the crisis, to stop accepting even Treasuries as collateral. The crisis convinced me that greed, ego, fear, short-sightedness, group-think and other human foibles have at least as much, if not more, to do with financial behaviour as rational thinking does.
This presents a tremendous challenge that policy makers, economists and bank supervisors are going to have to come to grips with.”
. . . . .
WILL THERE BE ANOTHER FINANCIAL CRISIS?
“Absolutely. As long as we have a financial system, we will have financial crises. The only question is how often and how severe.
Personally, I think a crisis is likely to happen sooner rather than later because . . .”
Click here to see Mr. Silva’s slide presentation on this topic
———————————————————————————————————————-* in one of the “lessons learned, Mr. Silva makes these comments (see page 15):
“Once a financial mob panics, the only thing that will end that panic is for a central bank with a large billy club to show up and announce: “Break it up everyone. Go home. This crisis is over.” Unfortunately, the Dodd Frank Act (DFA) has crippled the Fed’s ability to play this role. I guarantee that curbing the Fed’s emergency authority will come back to haunt us.”
Added note 2-16-19: The followup to this article may be found here.