Thank you, Sheila Bair

We are observing the five-year anniversary of one of the most tumultuous months in American economic history, September, 2008, when Lehman Brothers went bankrupt, and in which the entire developed world narrowly avoided a financial meltdown. Coincidentally, I recently met Sheila Bair, the former leader of the Federal Deposit Insurance Corporation, which, according to its web site, www.fdic.gov, “is an independent agency created by the Congress to maintain stability and public confidence in the nation’s financial system by insuring deposits, examining and supervising financial institutions for safety and soundness and consumer protection, and managing receiverships.”

Ms. Bair led the agency during one of the most challenging times in our nation’s history for financial institutions, the crisis that developed throughout the last decade, and exploded into the Great Recession five years ago this month. Few people outside the government and the financial community realized how much at risk our financial system was in September, 2008. But for the acquisitions of Merrill Lynch and the availability of private financing at Morgan Stanley and Goldman Sachs (which secured a critical investment from Warren Buffett,) our major investment banks were all at risk. AIG needed a federal bailout, and even GE was at risk because of its inability to secure short term credit.

Ms. Bair wrote a book in 2012, called Bull by the Horns: Fighting to Save Main Street from Wall Street and Wall Street From Itself, which recounts her experience during this crisis, what led up to it, and what followed it. She is an exceptionally rare public official, someone with the brainpower, experience, values, and courage to understand at both a detail and a strategic conceptual level what needed to be done to protect the public interest. Although other public officials were well-intentioned, they appeared not to have the vision to understand how short term actions, particularly the bailouts they were advocating, were likely to compromise the long term health and stability of the financial system.

Public anger about bailouts is remarkably astute, even if it often got expressed in a largely inarticulate, incoherent fashion. Ms. Bair did a remarkable job understanding what should be done, and what would create bigger downstream issues.

She was single-minded in focusing on a handful of key objectives:

• Making sure that banks of all sizes were adequately capitalized for the risks they were assuming, particularly in focusing on the quality of the loans they were underwriting;
• Eliminating bank bailouts with taxpayer funds, and using time-tested mechanisms for restructuring troubled banks and non-bank financial institutions;
• Focusing on minimizing foreclosures and maximizing loan restructuring to keep more Americans in their homes; and, perhaps most important of all,
• Insuring that the Dodd-Frank legislation would be designed and implemented to prevent, as much as possible, future financial crises.

By her own admission, she was only partially successful, which I particularly respect. Few leaders are as humble and honest in admitting when they have failed.

Several points she made frankly scared me:

• Many government officials single-mindedly focused on protecting the existing management of a handful of poorly run banks, particularly Citigroup, and, even seemed to be more focused on protecting their executive compensation packages than protecting their retail depositors. Unfortunately, special interests had far more influence, even in a crisis situation, than they should have had.
• A number of accounting, investment structure, and compensation decisions had extremely negative unintended consequences. For example, the multi-tier structure of mortgage backed security investment pools made the investors in the safest and top part of the pool financially incented to favor foreclosures over loan restructurings. In the foreclosure situation, they would get all proceeds and take no losses; in the restructuring situation, they would share the losses with lower-tier investors. As a result, there were far more foreclosures than would have taken place if the original lenders still held the loans or if the mortgage security pools placed every investor similarly.
• The even greater financial crisis in Europe was partially created by a flawed capital risk methodology adopted as part of what was called the Basel II framework (named after the city of Basel, Switzerland, where it was negotiated). Many U.S. bankers and regulators favored U.S. adoption of Basel II for U.S.-headquartered banks. Had that happened, the financial and banking crisis here would have been far worse. Banks would have had about ¼ of the capital in reserve than they had at the time of the financial crisis, and more would have failed.
• The FDIC is an insurer of retail deposits up to $250,000, but it did not have the mechanism for collecting adequate insurance premiums in advance from participating banks, because the industry forces successfully lobbied politicians to prevent the needed fee increases.
• The Fannie Mae and Freddie Mac government-sponsored enterprises that purchase mortgages from the banks that originate them were some of the most reckless participants in the exotic financial instruments that would have brought down AIG and the banks had they not been bailed out. Executives from these companies made millions of dollars each year from this recklessness. These organizations were not created to operate like theinvestments banks they became, but to enlarge the potential for banks to originate more mortgage loans to prospective homeowners. The federal government is still carrying a major loss in its investment in these two organizations.

The Dodd-Frank legislation helped to address the worst excesses and abuses that triggered the Great Recession, but it did not go far enough. Moreover, many implementing regulations have yet to be written.

Unfortunately, one of its unintended consequences is that smaller community banks with lower asset levels probably will not survive. One banker told me that, whereas a bank could be profitable at $1 billion of assets before the financial crisis and Dodd-Frank, the minimum profitable size for a bank today is $3 billion of assets. There will be fewer banks, particularly fewer small banks that are better able to meet a community’s unique needs.

On this last point, communities around the country will lose not only the benefit of a bank to make loans to deserving individuals and small businesses, but they will also lose the contributions to not-for-profit organizations and local trade associations and Chambers of Commerce. There are fewer of great community bankers left in Connecticut because the large banks have acquired the smaller banks that were critical to many community-based initiatives.

The financial crisis left many longer-lasting scars in our economic system and our psyches. We are blessed that leaders like Sheila Bair were there to protect the public interest, and as we reflect on the crisis that hit its high point five years ago this week, we should realize that getting the right people to make the important decisions in regulating our financial system is more important than ever.