On May 18, Neel Kashkari, former interim head of the Treasury Department’s Office of Financial Stability, spoke at Wharton’s San Francisco campus. The speech covered his views on the causes of the crisis; the reasons why the Treasury Department had to seek authority to set up a $700 billion bailout program; how that authority was used to keep the financial system from collapsing; and where the economy is headed. After the lecture, Kashkari discussed these issues with members of the audience. Knowledge at Wharton presents a video report of the lecture and discussion.
The Question and Answer portion of the lecture followed a presentation by Kashkari. (Because of technical difficulties, some questions from the audience are unclear in the recorded video, but these have been edited or paraphrased in the transcript below.)
Questioner: Maybe you could begin by commenting briefly on your career that took you out of Goldman Sachs up to today. It would be helpful to hear your background, from the government service perspective.
Kashkari: Sure. I began my career as an aerospace engineer before going to Wharton. Worked in engineering for a few years, and then went to Wharton, hoping to combine engineering and business. I didn’t know what I was going to do when I left Wharton. I ended up joining Goldman Sachs as a technology investment banker in San Francisco, as the optimal way for me to try to combine technology and business. I had a great experience. I had always had an interest in government, and when I’d been at Goldman for four years, and I applied for a program which many of you may know about, called the White House Fellowship.
It is a very prestigious program, and very competitive. The senior partner that I worked for at Goldman arranged for Henry Paulson, then CEO of Goldman Sachs, to sign a letter of recommendation on my behalf. This was in January 2006. I applied for the program, got halfway through, got dinged in the regional finals. Some of you may know what that is. I was very disappointed. And by the grace of God, a few months later, President Bush selected Henry Paulson to be Treasury Secretary. So I called him up and I said, “You remember me? I had met with you, I wanted to apply for this program. If you’re putting a team together, I want to come with you. I don’t care what you’re going to have me do. I just want to come in, and I’ll prove myself.” And it worked out. I got very lucky. I mean, it’s a great lesson, you know. It was a lesson for me, and for all of us. I had my heart set on something. I thought it was exactly what I wanted. I didn’t get it. I ended up getting something much, much better, and I’m very blessed for having it.
Questioner: I have two questions. The first is about the stress test. How do you think that will influence regulatory trends going forward? Now, I know the government said this was sort of a one-time public thing. But just going forward in a private sort of way, how do you think it will affect the regulatory trends for banks?
Kashkari: Let me give some context. I’ll answer your question. I want to give some context for everyone else here. So, the regulators and Treasury undertook a stress test, which I talked about, for the 19 largest banks. There are already-existing capital standards for banks that are established, and that have been established for a long time. And what Treasury and the Fed did this time, is they said, “Let’s look at these biggest banks, these systemic banks, and look out over the next two years and say, if we forecast a more severe economic scenario than people expect today, will the banks have enough capital? And will they have the right kind of capital to be able to continue lending through that more severe scenario?” But they were very careful to say that they’re not creating a new capital standard. So, while they’re not going to change how much capital a bank needs to hold three years from now, or five years from now, I think that they’ve learned a lot about trying to apply a consistent view across institutions.
Typically, what happens is, a regulator looks at, with company management, an individual institution, looks at their loan portfolio, looks at their business, and takes a fairly narrow view of, is that institution sound?
What this stress test has done is given the regulators a broader perspective to say, “Is this institution sound? How does it compare to other institutions? What’s happening in the broader financial landscape?” So, what I’ve heard from the regulators — I was not a regulator — was, they’ve learned a lot from this, and it’s been a very valuable experience. And that they’re going to incorporate elements of this into their more normal supervisory work going forward. Did I answer your question?
Questioner: Yeah, but could you make it more forward-looking…
Kashkari: I think to make it more forward-looking, and to apply more consistency across institutions. You know, they’re not only looking at what’s in a bank’s portfolio — securities, loans. They’re looking at the earning power of the individual institution. They’re looking at different macro effects.
Questioner: And the second question I had was, as you said, banks that received TARP funds were strong banks. What do you think the government will do when a strong bank gets into trouble? Is it likely then that they would have access to more government capital because they’ve been deemed a strong bank?
Kashkari: I think it depends on whether a bank is deemed systemic or not. We segmented the world into two camps. Healthy banks, who we wanted to make even healthier so they could support lending, and systemic banks. If you have a bank that is neither healthy nor systemic, then we have something called “receivership,” where the FDIC comes in and winds down the bank and sells it. So, I think it really depends on the situation.
The other thing to consider is, when we’ve had to intervene on individual institutions, the context of the financial markets and the context of the economy are very important. So, look at Bear Stearns. If Bear Stearns had happened, instead of March 2008, in March 2005, when markets were normal and healthy, we may have reached a different conclusion. Maybe — I’m speculating — maybe we would have concluded Bear Stearns is not systemic in 2005. But given the fragility of our capital markets, we felt that we had to take the action that we took. So, it’s a complex answer to say that we look at each case individually in the context of what’s happening around at the time.
Questioner: So, it’s not a reluctance to lose the TARP money that’s already been invested?
Kashkari: Well, I don’t think that — we established a standard, the healthy bank standard, where we said, “We want to evaluate whether or not a bank is deemed viable, before we put any government money in.” We didn’t want to put money into banks that ultimately were going to fail, if we could avoid it. Now, we’ve invested in almost 600 banks. I can’t imagine we were perfect. I also don’t believe that putting good money after bad is a good idea, if the bank is deemed not systemic.
Questioner: I wonder what the criteria were, or Treasury’s criteria, in giving out money to some banks but not others, and helping other banks get acquired. Because some banks, like Washington Mutual and Lehman Brothers, were left on their own and did not receive assistance.
Kashkari: This is a very complex question. Remember, in the case of Washington Mutual and Lehman Brothers, the TARP did not exist. So, let me take two examples, to start with. Let’s take Bear Stearns, and let’s take Lehman Brothers. In neither case did the TARP exist. Lehman Brothers failed on Monday. On Thursday, September 18th, we went to Congress. So, we couldn’t have done what we did with TARP there, because we didn’t have the legal authority. In the case of Bear Stearns, Bear Stearns happened very quickly. In a matter of a week or two, it went from everything is fine, to tremendous funding pressures, to a near collapse.
Treasury didn’t have the legal authorities to intervene. The Federal Reserve has very powerful authority to lend money in exigent circumstances. But the law requires the Federal Reserve to be secured with secured collateral, when they make those loans, so they’re not taking much risk. So in the case of Bear Stearns, there was a collateral pool of $30 billion of mortgages and mortgage assets that the Fed lent against, and that collateral secured the loan that they made. And that collateral was available, so they were able to loan against it.
Now, after Bear Stearns failed, the markets — the expression we use is, the markets turned their attention to the next-slowest deer. Okay? The next-slowest deer was Lehman Brothers. So, Bear failed. All of the market’s attention turned to Lehman. Lehman started coming under pressure. Over the course of the next six months, if you watched their stock price, you looked at their CDS spreads, Lehman came under more and more and more and more pressure.
Now, I was not in New York — I was in New York for the Bear weekend, I was not in New York for the Lehman weekend. So I didn’t work on Lehman personally. But it is reasonable to conclude that as Lehman was coming under more and more pressure, whatever quality collateral they had, they were having to pledge to other private-sector funders, to try to keep themselves afloat. So, after six months, Lehman finally runs out of funding and is going into bankruptcy, or about to go into bankruptcy. By then, there was no collateral left for the Fed to then lend against and meet their legal requirements. So Secretary Paulson and Chairman Bernanke have spoken about this a lot, and said very clearly that in the case of Lehman, it was not a question of will and desire. It was a question of legal authority to take the action. In the case of AIG, they lent against assets. Then we got the TARP authority, which, for the first time, enabled us to put in equity, or to really take a risk. I mean, at the end of the day, this is about the government, the taxpayers, taking risk in the financial sector.
The Fed is lending money against secured assets. They’re not taking much risk. The private markets were unwilling to take risk. We had to be able to take risk. That’s what the TARP was about.
Questioner: Over the last year, you’ve determined that there are certain institutions that are too big to fail, and obviously that’s part of the rescue. As you look ahead maybe five or ten years, one question that’s probably being wrestled with now is, are these institutions too big to exist? And as you look ahead, what does the financial landscape look like ten years from now, when hopefully this is in the rear-view mirror?
Kashkari: There will be and should be large regulatory changes that come about as a result of this. There’s momentum building in Washington for such regulatory changes. My personal view is, I think we should take our time because these are very complex issues. And we will benefit from getting the crisis behind us, studying it with the benefit of time, to really make the right changes.
You know, you could see how complex this is. If you have some huge global institution that is systemically important — too big to fail, too interconnected to fail — then, in a sense, it will always be able to issue debt cheaply because the people who buy that debt believe that the government is standing behind it. So, what do you do about that? You know, there are some people who are proposing that we should put a tax on all of these institutions that are deemed systemically important, to effectively increase their borrowing costs, so that they no longer have a competitive advantage over institutions that are not too big to fail. You could call it a debt tax, or systemic tax. I don’t know. I don’t know if that’s the right answer. But I think that the regulatory changes that come out of Washington over the next several years are going to have a large effect on what the financial landscape looks like in five or ten years, or in 20 years. It’s going to take a while.
If you look coming out of the Depression, the massive changes in government regulations and in government agencies and institutions, it took a long time for those to all form and for the market to adjust to those new realities. So, I don’t have a good lens into what that’s going to look like. I do know it’s going to be different.
Questioner: You talked about the TARP having strong protections on executive compensation. How does AIG figure into that? Weren’t there $400 million worth of bonuses paid out there?
Kashkari: Sure. The bonuses paid in terms of AIG, which got so much attention, were entered into in iron-clad contracts in the spring of 2008, six months before, or longer, before the federal government got involved in AIG. Now, we didn’t have the legal authority to tear up contracts. All right? We’re a country of laws. The sanctity of a contract is the bedrock of our capitalist system that has really differentiated the U.S. relative to other countries that investors could invest in.
Now, I talked about something called “receivership.” When an individual bank fails, a small bank — a thousand little banks failed in the S&L crisis in the late ’80s, early ’90s. The FDIC comes in and puts the bank into receivership. And that is a legal framework, under which the FDIC can then repudiate contracts. It can decide, “We’re going to pay this contract. We’re going to pay you this amount or this amount. We’re going to honor these. We’re not going to honor these.” For these large global institutions like AIG, or like Citigroup, that are these big global bank holding companies, there’s no receivership authority. So, one of the things that the new — the current administration is asking for, and Secretary Paulson and Chairman Bernanke asked for it last year, was new authority to put these big global bank holding companies into receivership, to give us these tools. The problem with having to intervene to stabilize an institution when you don’t have this legal authority, you don’t get to pick and choose which contracts you want to honor.
If we went into AIG and said, “We’re going to just arbitrarily tear up certain contracts because we feel like it,” those creditors could then put the company into bankruptcy. They’d have the legal ability to do that. And that would undermine the very stability that we’re looking to achieve. So, we did put in place strong executive compensation requirements. Congress passed — part of the TARP legislation required us to. But again, it did not go back and retroactively try to change contracts, because our system is built on the sanctity of contracts.
Question: We work closely with ABS Funds trying to raise capital for investment in vintage mortgage-backed securities. One question that we typically face from investors is, the bedrock of investor confidence is usually placed within the pooling and servicing agreement that was entered into. And with increasing activity in the loan modification space, it’s becoming very unclear as to how investor interests are protected, while borrower loans are actually modified. What do you see as a road map to protect investor interests in securities investment that they entered a long time ago but their loans are being modified at the back end? And, you know that the investors can be anywhere in the globe right now, not just in the U.S.
Kashkari: Just to give some context for everybody, all these home loans are packaged into mortgage-backed securities. You have your different tranches…Triple-A, all the way down. And there are these pooling and servicing agreements, which tell the services who collect your loan payments how you’re supposed to interact with the borrower. So, if a borrower falls behind, here’s what you’re supposed to do to try to maximize cash flow. Now, the servicers are trying to maximize cash flow for the investors in the aggregate. They’re not supposed to be picking and choosing which tranche of investors to be favoring. They’re supposed to be acting on behalf of all of them. The loan modification programs that have been designed that I’ve worked on are designed to try to help home-owners who want to stay in their home and have a reasonable chance of staying in their home.
Some people bought homes they could never hope to afford. And modifying their mortgage is not going to help them, it’s not going to be good for investors. These loan modification programs are designed to be very targeted, to help those homeowners who want to, and can fundamentally afford a reasonable mortgage. The analysis that we’ve done suggests that those type of loan modifications are, in fact, in the interests of the aggregate of investors. Now, there may be some investors, depending where they sit in the capital structure, they may prefer a foreclosure, okay? But the investors in the aggregate — if someone can afford to make a reasonable payment, that is better for the investors in the aggregate. So, we’ve designed this on the front end, to take investors’ views into account.
The interesting thing, though, is — some of the minority investors who, let’s say, prefer foreclosure, are very loud. Right? And they squeal a lot, and they threaten servicers, and they say, “Don’t you dare modify those loans. Put them into foreclosure, or we’re going to sue you.” And so by getting the industry to move at once, and getting the federal government to come in and support a view of helping targeted homeowners who want to stay in their homes, where it’s in the investors’ collective interest — we think that’s striking the right balance, and stopping short of abrogating contracts.
Questioner: Getting back to the stress tests a bit. When we talk about what the assumptions were for the worst-case scenarios, some of the things that I’ve read have kind of put us — potentially not beyond that, but certainly on a path to go quite far beyond what was originally predicted as sort of the worst-case stress scenario. And I’m wondering, you know, is there a plan C? What happens if employment exceeds 8.9%, and real estate doesn’t find a bottom, and the commercial real estate problem is much larger than — you know, it’s kind of an unknown right now. You know, 1.8 million sub-prime mortgages almost brought the banking structure to its knees, and we’ve got 8.1 million alt-As starting to reset at the end of this year. What’s the case beyond the stress test case, and where do you see that bringing us as a country?
Kashkari: It’s interesting, because there certainly are some commentators who say the stress test was not pessimistic enough. But a lot of the banks say, “Are you kidding me? This was far more aggressive than what we think is credible,” given what they’re seeing in their loan portfolios. So, I don’t think you’re going to ever make everybody happy. I think the Treasury and the regulators tried to find the right balance. The biggest risk we now face is political risk. If the economy stabilizes the way the optimists think it will, where we could see GDP growth as early as Q4, bottoming some time this year, I think we’re going to be fine because I think that that vicious cycle will be broken and it will start to unwind. And the programs that we have in place will be appropriate, given the economic fundamentals.
If the economy deteriorates much, much further than we expect, then I think we may need to go back to Congress to get additional authorities to stabilize the financial sector, and to continue to get lending going again. And that’s going to be tough. Because right now, the political environment is so bad, almost every member of Congress is saying, “Don’t come anywhere near us right now, asking for more authority.” I certainly hope it doesn’t come to that. And again, many economists don’t think it will come to that. If the recession gets much, much worse, the American people will feel it. And that’s why we did this. We did this for American families. And members of Congress will feel it. And they will hear it from their constituents. Again, I was very skeptical in the two years I was in Washington, at Congress’s willingness to move, and take unpopular action that was necessary. But look what they did. When the people spoke, and when we faced the crisis in the fall, they acted in just two weeks. If the economy gets substantially worse, I think Congress will need to act, and they will act.
Questioner: Is there a point at which it’s not better to keep putting money into the banking system? Or is that always the right answer?
Kashkari: I mean, I guess the question is, if we don’t do it — credit is — people describe credit as the lifeblood of our economy. If we are not able to provide credit, if our financial system is not functioning, we will have a deeper, longer recession than we need to have. And that’s the choice we have to ask ourselves. Do we want to — even as distasteful as this is, would we rather have a longer, deeper recession? I think most people would say no.
Questioner: Two quick questions. The first one is, Americans have been encouraged by the Administration to go off, refinance, take advantage of the lower interest rates. The problem is, as you alluded to earlier, appraisals come in lower. There’s been a decline in home prices. So effectively, it’s kind of two-sided. You can get better rates, but you have to pump more money into your property to maintain those rates. I’m wondering what if anything should be done about that? The second question is, I saw your interview on Charlie Rose. I thought it was great. I’m just curious why you left government, and what you’re planning to do next.
Kashkari: So, the first question is about underwater borrowers, which has gotten a lot of attention. You know, for — in August of 2007 — so, I’d been at Treasury for a year. Secretary Paulson asked me to lead the Department’s work on housing. So I looked at — with the Department, and with the Fed, dozens and dozens of homeowner programs. Housing programs, foreclosure programs. And the issue of what to do about people who are underwater is a really tough issue. Because when people get way underwater, they may not want to stay in their house any more. So I always talk about wanting to help people who want to keep their home. Okay? If you’re underwater, and you don’t want to keep your home — people like to do this analysis. Let’s say you call up your bank, and you said, “Hey, look. I’m underwater. If you don’t cut my principal, reduce my mortgage balance, I’m going to walk, and you’re going to have a foreclosure.” That seems like that’s a bad trade for the bank. The bank should cut your principal, because maybe they’re only going to get 60 cents on the dollar in foreclosure.
The problem is moral hazard. Because if you do it, every one of your neighbors is going to pick up the phone and say, “Hey, cut my principal, too. I’m going to walk if you don’t cut my principal. I’m underwater.” And that moral hazard problem — the banks would rather lose you to foreclosure than modify every home on your street because the economics are better to lose you to foreclosure. So, the underwater problem is something economists love to talk about. But they haven’t thought through the practical implications of, if you own a bunch of loans, how you modify them? Which ones do you modify?
The hard part about housing is, again, targeting the assistance to the homeowners who need it, who can benefit from it, without creating the wrong incentives for all the other homeowners on your block, or without providing that assistance to the banks and the mortgage-backed securities investors, rather than to the homeowners who need it. So, you’ve identified a huge problem that I’ve not heard a good solution for. One thing that this administration has done is, if you happen to have a Fannie or Freddie loan — Fannie Mae or Freddie Mac loan — typically, you need to have 20% down to get a Fannie or Freddie loan. But let’s say you have a Fannie Mae loan today, and you’re now at 100 loan to value (LTV). So, you were in at 80. Your home has lost 20% of its value. You’re now at a 100 LTV. Fannie Mae already owns your risk. So, what the administration has done is said, “Look. If you’re already a Fannie Mae loan, Fannie Mae can now refinance you up to 105 LTV.” It’s not increasing the risk of the government, because they already own the loan. But it’s enabling you to achieve a lower interest rate, which actually lowers your risk. So, that’s a clever, narrow area where we can try to address this problem. But beyond that, I’ve not heard a good solution to that.
In terms of why I left government — I was an appointee of the Bush Administration. President Bush and Secretary Paulson appointed me. So, my term was due to expire on January 20th with all the other Bush appointees. The Obama Administration and Secretary Geithner asked me to stay for a brief period to help with the transition. And it ended up being a lot longer than I expected. I concluded my service on May 1st, when my successor was announced, and had then come into Treasury. And we transitioned for a few weeks. So, it’s — I mean, three years in Treasury was a long time in this period. And I’m looking forward to taking some time off, and then re-entering the private sector. I have no idea what I’m going to do yet.
Questioner: Somebody had asked about the commercial mortgage markets, which effectively collapsed. It just hasn’t been visualized yet, because people are still hanging on to their properties. So, what do you see as the government’s attempts to shore up the commercial market the way they have the residential market? And then, secondly, if you could comment on your views of how all this funding and infusion of capital is going to affect inflation?
Kashkari: The second one’s hard. The first one, regarding the commercial mortgage market — that’s an area of stress that a lot of people are pointing to as the next shoe to drop, so to speak. You know, commercial mortgages and commerce are very tied to our macro fundamentals. So, if our macro-economy comes under a lot of pressure, it’s common to expect that the commercial market is going to come under pressure.
The best tool we have right now, and the most promising tool, is this program I mentioned called the TALF program, where the Fed is going to be extending — likely going to be extending the duration of the lending that they’re going to provide, the loans that they’re going to provide, to commercial mortgage-backed securities. One of the big challenges right now is not just people falling behind on their commercial mortgages, it’s roll-over risk. People who need to refinance, but the markets are frozen right now. So, as we get this TALF program expanded, we think that that can really help re-start the commercial mortgage-backed securities markets. We announced the TALF program in November. It’s a very complex program, and it took four or five months to get up and running. It started functioning in March. But even at program announcement, we saw markets react in anticipation of the program. And we’re starting now to see securitization markets begin to show some thawing. I think this month, they did $10 billion of transactions. The previous month, we’d done $3 billion.
Question: That’s focused on new securities, rather than legacy securities.
Kashkari: I agree. But if you look at the Treasury announcements, they’re focused on two things. Expanding to include other new asset classes, including commercial mortgage-backed securities, which could be refinances of existing commercial mortgages, as well as something we call Legacy TALF — expanding TALF to include legacy mortgage-backed securities, including both residential and commercial. Expanding TALF to legacy is not going to help the individual property owner but expanding TALF to new commercial mortgage-backed securities will. And so we think both of those in combination will help to re-start the market. All of this is about trying to get private capital flowing back into these markets. And again, I think we’re seeing some early signs of progress, but it’s still very early.
Oh, inflation. [LAUGHTER] You know, I would have to defer to my colleagues at the Fed. There’s no question, inflation is a risk any time the government is spending so much, and borrowing so much. But I think given where we are, our economic fundamentals, I think the choice is pretty clear, that we need to do what we’re doing in the financial system and the economy to get through the crisis. And then we need to unwind our programs in a prudent manner once we’re through it. Right now, if we have to err, I would err on the side of being more aggressive, rather than less aggressive. Let’s get through the crisis. Let’s put the fire out, let’s be sure that it’s out and then let’s deal with our longer-term fiscal situation, which is very important.
Questioner: The idea of leverage has been demonized in the middle of the credit crisis. And obviously, leverage has its pros and cons. So, I wanted to hear how you think about what’s appropriate and wise. And then the second question is, what kind of opportunities for MBAs do you see in federal government going forward?
Kashkari: So, leverage has been demonized. I think that few people would argue that some of our largest banks didn’t have too much leverage. Non-banks, in particular, had too much leverage. I also think there’s too much leverage across our financial system. Individual Americans didn’t save enough and had too much leverage. I think that the illness, or the symptom of too much leverage manifested itself throughout our financial system. It’s hard to argue that there was not too much leverage. We’re going through a de-leveraging process right now. And where we settle this new equilibrium is going to be very important in terms of what our economy looks like in the future.
We don’t know where it’s going to settle right now. Savings rates have gone way up, from — way up. It’s still only 4% or 5%, but it’s way up relative to where it was just a year or two ago. So, I think that — leverage — you’re right, has a role to play. It’s not, “We should all have no leverage.” But it needs to be prudent, and it needs to be rational. Did I answer your question on leverage?
Questioner: Yeah. If you have any more specifics…
Kashkari: I don’t, because it’s so situation-specific, in terms of individuals, in terms of banks, in terms of non-banks, et cetera. It’s hard for me to generalize.
In terms of MBAs in government — you know, I didn’t know what to expect when I got to Treasury. I came from the private sector, both as an engineer and as a banker. And I think I had an expectation that people don’t work hard in government, which couldn’t be further from the truth. People are working very, very hard, day in, day out. Not just because of the credit crisis. But now in particular, the last couple of years.
You know, we at Treasury, in the Office of Financial Stability — Treasury’s a policy department. So, it writes papers, and it writes policy proposals year-in, year-out. It’s not an investing department. So we had to build this from scratch. So, the TARP legislation created something called the Office of Financial Stability, which I ran. And I was the first employee of the office. In the last six months, we hired around 135 or 140 people, full-time people, dedicated to financial stability. We hired people from within the government, out of schools, from the private sector, from banks, from consulting companies, from law firms. All people coming in, trying to help out, do whatever they could to try to make our programs successful. So, I would encourage folks who are interested in government to look. It doesn’t have to be at the federal level, it could be at the state or local level. I think there are great opportunities to take on large responsibility early in your career, to really be a part of something important. And I think you can develop good skills that I do think are transferable back to the private sector. I certainly hope they are. But I would encourage it. And I think that — figure out what you’re interested in, and — you know, go to their Web sites. Meet people who are in government, et cetera, and try.
Questioner: Some 30% of the TARP funds that have been deployed so far have been invested in Citi and Bank of America, if I’m correct. About $90 billion. Can we reasonably expect that to be repaid? And do you have a time frame roughly how long that will take? And can TARP be profitable for the taxpayers if that doesn’t happen, because it’s such a huge portion of TARP?
Kashkari: I don’t think it’s appropriate for me to speculate about individual institutions. I will say that when we have had to intervene to stabilize individual institutions, the money that we’ve invested, those have been higher-risk investments than when we’ve made the more general investments in these hundreds of banks. So, AIG’s in that category. General Motors is in that category. Chrysler’s in that category, as well as Bank of America and Citi. I think that if you look at those two institutions, those were part of the stress test. The regulators have gone through, analyzed their balance sheets, analyzed their capital positions, and have given them feedback in terms of what additional capital they need to raise.
So, I think the way we’re going to get paid back as much as possible is by banks and institutions earning money over the long term, and paying back the money over the long term. I can’t put a time frame on when these institutions are going to pay us back. About a dozen small banks have already paid back the TARP, and many other banks are applying right now. For those big institutions, it’s hard for me to say when and in what form.
In the case of Citi, this is all public. We have announced that we’re going to enter into an exchange offer, and convert some of our preferred stock for common stock. And Treasury’s in the process of developing policies on when it would then sell that common stock. And so there are a lot of variables as to what happens in the broader economy, what happened to the institution. What happened to the banking market, to try to forecast when, and for how much.
Questioner: You mentioned early on in your talk that you were reluctant to act in the crisis, because there are often unintended consequences of those actions. Someone already mentioned inflation, but are there any other unintended consequences that you’re seeing in the market or expect to see maybe five or ten years from now?
Kashkari: One of the biggest consequences that I’m concerned about — I don’t see it yet, but I’m concerned about, is — we want the TARP to be temporary and to wind down after a few years, once the markets are stabilized. If you look at The Great Depression — and housing was part of the problem in The Great Depression — four major government agencies were created coming out of The Great Depression. Fannie Mae, the Federal Housing Administration, the Federal Home Loan Banks, and the Homeowners Loan Corporation. Three of those four are still in existence today. And no one in the 1930s could have predicted that Fannie Mae would pose a systemic risk to our country 80 years later. So, we certainly hope that the TARP and the Office of Financial Stability is a temporary program that is wound down soon, after it’s run its course. But you never know, and that’s a risk.
Also, if you look at what we’ve had to do in the auto companies. It’s nothing we wanted to do. We wanted, in December, for Congress to act. Congress was working on legislation to try to deal with the auto companies. TARP was focused on the financial sector. It was not the right vehicle. But we were forced. Congress knew we could act, frankly. And so they didn’t take the hard measure to pass their own legislation and we were forced to act, given how perilous the broader economy was at the time. It’s not impossible to envision, with this type of an authority, that it could be misused to stabilize favored industries that may not be systemic. That’s something else I think we should be very careful of, and to try to design against, and prevent that from happening in the future. So again, I’m not seeing it yet, but those are things I worry about.
Questioner: One of the cornerstones of the American Dream is obviously said to be owning a home, right? Do you really feel that that’s still the case, given all the things that have happened in the housing sector? Is it still a meaningful dream, for everyone to have a home?
Kashkari: I don’t think that dream is for everyone. I think the experience of the last couple of years proves that. If you look at — I can’t remember the number but if you look at the percentage of Americans owning homes, it had been fairly stable for many years and then it climbed up in recent years. Homeowners maybe who should not have been owning homes, but who should have been renting, were getting into the market. And so I think that there is a balance that needs to be struck. And I don’t think it’s necessary for the government to say, “This is the percentage of Americans that should own their home.” But I also don’t think it’s realistic to think that everybody’s going to have the financial capacity to own a home. I think, clearly, some people need to be renters. And that may change. You know, people may rent and own in different parts of their life.
Questioner: I’m in the mortgage industry. A lot of this upheaval in the markets started when you started coming up with creative mortgage products in the part few years, try to bring zero-down payment loans, and that kind of stuff. And it led to this collapse. What makes you think this is not going to happen again, when you’ve got FHA still doing loans with 3 ½% down, borrowers with credit scores that just now became 620, and until a month ago was zero FICA could get a home. Aren’t you creating another wave of the same problem? Some of the banks that you’re lending money to are adding a second lien mortgage and letting a borrower buy a house with half a percent down. So, what is there to check that something that started, and has resulted in this, is not going to happen again?
Kashkari: So, let’s unpack what you just said because there’s a lot in there. FHA, the Federal Housing Administration, makes loans to Americans with as little as around 3% down.
Questioner: Three and a half.
Kashkari: I thought it was three.
Questioner: No, it changed this year.
Kashkari: Okay, and people would argue that that’s risky, and that’s a fair point. The point of FHA is to try to provide — especially for first-time home buyers, the ability to get in to buy a house. People legitimately say, “Gee, isn’t that risky?” That’s a fair point. So, we are taking a risk, as people are buying new homes, their first time. At the same time, we have to strike a balance here. Because if we raise underwriting standards so high that most people cannot buy homes, it’s going to put even more pressure on the mortgage markets. One of the things we had to do last year — we’ve spent a lot of time last summer designing programs to stabilize Fannie and Freddie. That was absolutely essential, because we needed to keep credit flowing to the housing market.
We have a necessary housing correction. Home prices need to adjust back down to where ordinary people with regular jobs can afford to buy a home in their neighborhood. Okay? It’s fundamental affordability. That could be an overcorrection, or it could be a very disorderly correction, if the flow of credit to the housing market dries up. And if you own a house but you can’t sell it, because no one can afford to get a loan, what’s the value of that house? It ends up plummeting. And so ensuring that the government was there to provide credit to keep the housing market functioning was very important, to allow the correction to progress while trying to minimize damage to the economy. So, I take your point on FHA. If you look at virtually every private sector source of housing finance, underwriting standards have taken off. Okay? You don’t see that?
Questioner: No, because — your toxic assets — you bought loans that originated before March of ’08, right? That’s — we’re buying with TARP funds. Until January of this year, if you’ve got a lender like Bank of America lending without any income documentation, you’ve got the same problem that’s going to happen or manifest three years from now.
Kashkari: Well, I’ll have to defer to you on whether Bank of America or any other lenders were offering no-doc loans in January of this year.
Questioner: Until January 17th of this year.
Kashkari: I’ll just be candid with you. I’ve heard the complete opposite from everyone else that I’ve spoken with, including the banks, and including people trying to get loans. More often than not, the calls that I’ve been getting are, “I can’t get a loan. I’ve been perfect in my credit score, I made every one of my payments, and I can’t get a loan, and my bank just pulled my credit line.” So, you’re one voice, when there are hundreds of others in the other perspective saying that banks are tightening standards too much. Markets are pretty efficient after they’ve made a mess, right?
So, more often than not, people are saying that banks are being too tough right now. And what I say to people is that — as I mentioned in my talk — in recessions, underwriting standards tighten, and borrowers get more nervous about taking on new loans, so you see credit levels falling. We want markets to find the right balance. We don’t want them to be too loose right now. We want people to be able to get loans. But we also want them to be prudent. I don’t have a better answer for you than that. I’m surprised, because what I was hearing is that — you know, the crisis really reached a fever pitch around Christmas-time of ’07, and underwriting standards at most banks had really ratcheted up at that point, especially in housing markets. Now, it’s the other classes of loans, where people are continuing to tighten standards.
Questioner: You spoke earlier about the need to de-leverage. But the TALF program itself is just another form of leverage. So, isn’t it just this cycle? You’re just moving leverage from the banks onto private investors’ balance sheets.
Kashkari: Well, in this case, we’re moving leverage to the federal government’s balance sheet. So, again, this is all about the nature of the adjustment. We need to de-leverage, but what’s the speed at which that de-leveraging takes place, and how damaging is that de-leveraging process to our broader economy, while we reach equilibrium? So, if the government — if the Fed and Treasury did nothing, markets would find their own equilibrium. But it could have been incredibly damaging to our economy while they got there. So, programs like the TALF are trying to provide a more graceful approach to those new equilibriums. Things like the TALF are designed to be very expensive, relative to what normal market conditions provide. The cost of that leverage, as an example. So that when markets begin to heal, those programs will unwind themselves, and the private sector will return to using their other sources of leverage.
So again, I’m not disagreeing with you. It is another source of leverage. But again, it’s about trying to find a graceful approach to this new equilibrium. Did I answer your question?
Questioner: Yes. But when the program unwinds — you’re saying the hope is, at the end, it reaches that equilibrium. And that the government itself doesn’t want that equilibrium reached too quickly, which could be damaging. What’s the problem about it, though? I mean, that’s what I don’t understand, in the market. What’s the problem with having that big drop, and then having private investors come in at that point and meet it? Private investors have a lot of cash, and they are using the TALF as well as other programs, as well as just private equity funds and their own investments, to buy cheap assets. When it gets too cheap, they’re coming in, and they’ll buy it. And then that’s a fair price.
Kashkari: Sure. The problem is, look at what happened to us in the fall. In the first six months of the crisis, the fall of 2007, our constant message was, we were pounding on banks — “Raise capital, recognize losses. Raise capital, recognize losses” — hoping that the private sector could deal with this adjustment on its own, through private capital coming and doing exactly as you’ve said. But at some point, the private sector got too fearful, and pulled back from the financial system, and was unwilling to come in at virtually any price. And when the private sector’s unwilling to come in at virtually any price, the price plummets. You can effectively render your financial system insolvent, and collapse the financial system. And so, when — again, within bounds of reasonably normal market conditions, what you’re describing works perfectly. But when the private sector has such fear in it that the market just completely collapses, then the damage to our system can be catastrophic. And that’s not a risk we were willing to take.
Questioner: I was wondering, a lot of the economists have predicted that the sub-prime mortgage market was roughly $2 trillion to $3 trillion whereas the TARP money that you have handed out is around $700 billion. Do you see the $2 trillion to $3 trillion number close, or do you think the $700 billion that you have put in has plugged the bleeding for now?
Kashkari: Well, TARP was $700 billion, of which roughly $400 billion has been spent. Meaning, it’s either cash out the door, or contractually committed. Around $200 billion more has been allocated to various programs, leaving about $100 billion roughly unallocated. It’s important to remember, when you put in a dollar of equity, because banks are leveraged, that’s roughly equivalent to buying $10 of assets.
So, it’s not apples and apples to say $700 billion, and $2 trillion or $3 trillion of assets, because of the leverage effect, number one. Number two, TARP is one of many tools that we’re using to try to stabilize the system. The Federal Reserve has massively expanded its balance sheet by $2 trillion, supporting various asset markets. You have the TARP. You have the FDIC debt guarantee, which has guaranteed several hundred billion dollars of bank debt. So, combined, we’re talking about massive amounts of resources going at stabilizing the system. And so looking at sub-prime is important. Looking at mortgages in general is important. But all of our programs are designed at getting various components of the credit markets functioning again.
Questioner: Thank you very much for your presentation tonight. It’s been just great. The failure of our regulatory authorities is staggering in this crisis. And the failure of the credit rating authorities is staggering, at least in my view. Given how difficult it is to re-do those organizations, especially under the pressure of politics that have lobbying groups trying to minimize the real impact, is there anything that we can do? Is there anything citizens can do to try to give government the backbone it needs to really change these regulatory authorities, fix them — the credit ratings, which are private organizations? We will be back in the soup, if we don’t strengthen those institutions.
Kashkari: It’s a great question. You know, I look at the rating agencies a lot like I look at sell-side equity research…which is, you should know what you’re getting. Right? No offense, but you should know what you’re getting, and who they’re representing, and who pays their salaries. Now, I don’t put disproportionate blame on the rating agencies, only because every one of their models, and every one of the banks’ models, and every one of the investors’ models, all had the same assumption. Home prices only go up. And if home prices only go up, those models are brilliant. But when that fundamental assumption’s wrong, all those models don’t work any more.
I don’t know how you design a regulatory system or a rating agency system that is going to be able to push back against a belief that the entire country shares. Think about it, if you were a regulator. The entire country believes that owning a home is the American dream for every American, and we all believe that home prices only go up. And you’re somehow that regulator who’s going to stand up and say, “No, no, no. I know better, and you’ve got to trust me.” That’s a really tough thing to do. I’m not saying it’s impossible.
So I guess what I would say is, it is important to have an active dialogue with your representatives and your leaders, and demand that they lead. It is important that they do not just reflect the current emotion that we’re all feeling, and the excitement that we’re feeling about this market, or tech stocks, or what not. It’s a really hard thing that I have not heard a good solution to. But I think the best thing I can say is, the American people demanding that their leaders in Washington lead. That’s a hard thing. Anyway, thank you all very much. I really enjoyed it.