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.

Neel Kashkari: Good evening, and thank you, Doug, for that kind introduction. I would also like to thank Wharton for hosting this event today. You know, given the severity and the complexity of the credit crisis, I think it’s essential that we have a vigorous dialogue, to really understand the causes of the crisis, learn from it, and make sure that we can prevent these things from happening again. And I think that the Wharton community is ideally suited to contribute to that discussion. So as a Wharton alumnus, it’s really a privilege for me to be here with you today.

What I’d like to do tonight is first establish a foundation, by offering some prepared remarks briefly explaining what led to the crisis, why we had to go to Congress to seek unprecedented authority to create a $700 billion program, how we used that authority to prevent a financial collapse, and where we’re now headed. But then, what I really want to get to is a discussion. I want to spend the most of the time on Q&A, and hear from you, and have an active dialogue.

The Importance of the Financial System

Let me begin by reviewing very quickly how the financial system affects every American, and every American family. Banks, as you know, serve as a primary intermediary between borrowers and savers. Americans save for their futures, and for their families. And these savings of individual Americans are combined and made available to other people, and to businesses that need to borrow money for their specific needs. The financial system links millions of individual savers around the country with millions of individual borrowers around the country, through billions of individual transactions. This extraordinarily complex but usually efficient system includes both banks where you and I have our savings accounts, and non-banks, such as financial institutions that provide credit cards and car loans and student loan financing.

Now, this system has developed over our nation’s history, and it is built on confidence and on trust. Savers, be they individuals or businesses, need to have confidence in the institutions and the people they entrust with their money. And because no single bank can touch every family or every business, banks must have confidence to lend to each other for the system to work.

Causes of the Credit Crisis

With that background, let me briefly describe the fundamental causes of the credit crisis. The seeds of the crisis were planted during a decade of benign economic conditions, including low interest rates and low inflation. Financial innovation, which has served the U.S. economy well over the years, also accelerated. Investors gained increasing confidence in the effectiveness of new financial products to diversify and distribute risks. With this perceived reduction in risk, leverage increased across the financial system. Underwriting standards for mortgages weakened as more and more reliance was placed on the value of the home rather than affordability. Homeowners took out ever larger mortgages with little or no down payment and little or no documentation of income. Regulators, investors and homeowners took comfort from the belief that home prices only go up.

As we have learned, that belief was incorrect. To understand the consequence of that miscalculation, consider that the U.S. residential mortgage market is an $11 trillion market. With banks’ highly leveraged balance sheets and minimal down payments on home loans, even a minor drop in home prices and rise in defaults can result in a large hit to banks’ capital. Large losses can threaten the solvency of financial institutions.

Rooted in housing, this credit crisis is complicated by a number of related factors: First, home prices adjust downward slowly, in part due to homeowners’ reluctance to realize losses; most people would rather keep their home than sell for a loss if they can avoid it since it usually is their largest financial asset. Next, this necessary housing correction, which is not over, is setting the pace of the credit crisis. Finally, this slow adjustment makes it difficult to value mortgages and mortgage-backed securities, because investors don’t know for sure where the bottom of the housing market is and when it will be reached.

But investors are forward looking. With the high leverage in our financial system and the large and necessary housing correction, investors quickly realized that the financial system had insufficient capital to withstand the expected losses. But the opacity of mortgage-backed securities and the difficulty in valuing mortgage assets meant it was hard for investors to determine exactly which institutions were at greatest risk.

Not wanting to be exposed to a failing institution, but also being unable to determine for certain which institutions were at risk, investors pulled back wherever they could.

A capital problem for some institutions led to a liquidity problem for all institutions. That liquidity problem created a serious risk that our financial system as a whole, both in the U.S. and abroad, could fail.

Secretary Paulson and Chairman Bernanke recognized early that there might come a time when the private markets would become unwilling to provide the necessary capital to our financial system to deal with the large losses from the housing correction. In such a scenario, only the Federal government would be in a position to support the financial system — to step in to provide the needed capital to prevent a collapse. Although government leaders have numerous tools to combat financial market crises, there was no existing tool to provide capital to the financial system. Government intervention was not our first choice, as it often has unintended, far-reaching consequences. But it was a necessary choice. We began contingency planning in early 2008.

The crisis deeply intensified in the spring of 2008 and our major financial institutions came under severe pressure from deteriorating market conditions and the loss of confidence. In a short period of time several of our largest financial institutions failed. In March 2008 – Bear Stearns. In July – IndyMac. In September, we witnessed the conservatorship of Fannie Mae and Freddie Mac, the bankruptcy of Lehman Brothers, the rescue of AIG, the distressed sale of Wachovia, and the failure of Washington Mutual. Eight major U.S. financial institutions effectively failed in 6 months — six of them in September alone.

As a result, credit markets froze. The commercial paper market shut down, 3-month Treasuries dipped below zero, and a money market mutual fund “broke the buck” for only the second time in history. The savings of millions of Americans and the ability of businesses and consumers to access affordable credit were put at serious risk.

The Need for Government Action

Recognizing the threat to every American family, we knew the time had come to provide government support for the U.S. financial system. On September 18, we went to the Congress to ask for unprecedented authority to prevent a financial collapse. Congress also recognized this threat and just two weeks later the Congress passed and President Bush signed into law the Emergency Economic Stabilization Act of 2008. We worked hard with the Congress to build tremendous flexibility into the legislation because the one constant throughout the credit crisis has been its unpredictability.

The stress in the financial system I’ve been describing is reflected in something we track called the LIBOR-OIS spread, which is a key measure of risk in the financial system. Typically, 5 – 10 basis points, on September 1, 2008 the one month spread was 47 basis points. By the 18th, when we first went to Congress, the spread had climbed to 135 basis points. By the time the bill passed, just two week later on October 3, the spread had nearly doubled to 263 basis points. Credit markets continued to deteriorate and, just one week later, the spread had spiked to 338 basis points — almost 50 times normal levels. Our Nation was faced with the potential imminent collapse of our financial system.

What if the financial system had collapsed? Businesses of all sizes might not have been able to access funds to pay their employees, who then wouldn’t have money to pay their bills. Families might not have been able to access their savings. Basic financial services could have been disrupted. The severe economic contraction and large job losses we are now experiencing were triggered by the credit crisis. However, had the financial system collapsed, this recession, including terrible job losses and numerous foreclosures, could have been far, far more severe.

As conditions deteriorated rapidly, it became clear to us that we needed to use the authority granted by Congress as aggressively as possible to quickly attempt to stabilize the system. A program as large and complex as the TARP would normally take many months or years to establish. But, we didn’t have months or years. We had to move as fast as possible. We designed a Capital Purchase Program, to invest up to $250 billion in banks. It would be the fastest and most direct way to inject much-needed capital into the system and restore confidence. But a big question remained: Would banks participate? Banks traditionally resist government assistance because they fear it could make them look weak — and undermine the market’s confidence in them that is so vital to their business. If they didn’t participate, our plan would not work.

We asked the CEOs of nine of the largest banks in America to meet with us at Treasury on the afternoon of Monday, October 13, 2008 and asked them to participate in the new program. To their credit, they all unanimously agreed. Two weeks later our investments were complete. This action, combined with a guarantee of bank debt by the FDIC, stabilized the system and prevented a financial collapse. In short – it worked.

While we started with those nine banks, the program was designed so that healthy banks of all sizes across the country could apply. All banks, large or small, would get the same terms. In the 7 months since Congress passed the TARP, Treasury has now invested approximately $200 billion in 579 healthy, viable banks in 48 states, Puerto Rico, and Washington D.C., with new investments each week. The investments have ranged from as high as $25 billion to as small as $300,000. The median investment is around $15 million. Most of the banks Treasury is investing in are small, community banks that never got involved in the risky mortgages that led to the crisis. And there are hundreds of additional applications in the pipeline. It is important to remember, Treasury is buying preferred stock in these banks — not giving them money. Treasury has already received almost $3 billion in dividend payments. I expect the vast majority of these banks to pay back the Treasury in full with interest.

People often ask: Why is Treasury investing in healthy banks? Shouldn’t the TARP only be used for failing banks? Once we had prevented a collapse, our focus turned to minimizing the damage to the economy. We needed to get lending out to our consumers and businesses. Healthy banks are in the best position to support their communities by extending credit. A dollar invested in a healthy bank is far more likely to be used to promote lending than a dollar invested in a failing bank, which would more likely use it just to survive.

Treasury also helped the Federal Reserve establish a lending program to reduce borrowing costs for consumers, including auto loans, student loans, small business loans and credit cards. They are planning to expand this lending initiative to include other asset classes, such as commercial mortgage-backed securities. This program, the TALF, is under way and showing real promise helping restart the securitization markets that are essential to providing credit to our economy.

Under Secretary Geithner’s new Financial Stability Plan, Treasury and the banking regulators launched a stress test of the 19 largest banks to make sure they had enough capital and the right kind of capital to continue lending even in an economic scenario that is worse than expected. The results of those tests are complete and several banks are now raising meaningful new equity from private markets, which is both good for the system and a positive indicator of market improvement. Treasury also stands ready to provide additional capital if some institutions need it.

Treasury also launched a multi-part housing program to reduce borrowing costs and encourage long-term sustainable loan modifications. Finally, Treasury launched a public-private investment program to purchase illiquid assets from banks which has received strong interest from private sector participants.

During this time, we unfortunately had to step in to stabilize several large institutions whose failures would pose a systemic risk to our financial system and economy. We regretted having to take these actions — to put so many taxpayer dollars at risk to support individual firms that had made bad decisions. But the choice was clear when the consequences of inaction were so severe — and the potential cost to taxpayers of inaction so much greater than the cost of intervention.

Today, that LIBOR-OIS spread we track has fallen from a peak of 338 basis points back down to below 25 basis points. I believe the combined actions of Treasury, the Federal Reserve and FDIC have prevented a financial collapse, but there still is much more work to do to get credit flowing to our communities.

Update on Lending

People have been asking what the banks are doing with the money we’ve invested in them. We designed important features into our investment contracts to limit what banks can do with the money: one, we restricted dividend increases and share repurchases and, two, placed restrictions on executive compensation. By increasing a bank’s capital, the bank will have strong economic incentives to deploy the capital profitably. Banks are in the business of lending and they will provide credit to sound borrowers whenever possible. If a bank doesn’t put the new capital to work, its returns for its shareholders will suffer.

People have then asked: how will you track lending activity? In January, Treasury began collecting data from the twenty largest recipients of capital under the CPP, representing almost 90% of CPP capital investments. Treasury has now published the first 4 monthly lending surveys. These surveys show, bank by bank, the lending and intermediation activities of institutions by category, such as consumer, commercial and real estate loans. They are published monthly on Treasury’s website. In recessions, credit levels typically fall as both borrowers and lenders become more cautious. The surveys shows that lending held-up remarkably well at these banks despite one of the most severe quarterly economic contractions in decades. Without capital from Treasury, lending levels would likely have been much lower.

With investments in almost 600 institutions, and hundreds more in the pipeline, we must ensure that our investments are targeted at helping the economy but we must also take great care not to try to micromanage recipient institutions. However well-intended, government officials are not positioned to make better commercial decisions than lenders in our communities. The government must not attempt to force banks to make loans whose risks they are not comfortable with or attempt to direct lending from Washington. Bad lending practices were at the root cause of this crisis. Returning to those practices will not help end this financial turmoil.

The provision of credit that is vital to our economy will not materialize as fast as any of us would like, but it will happen much faster as a result of deploying resources from the TARP to stabilize the system and increase capital in our banks.


The bursting of the housing bubble damaged our financial system, which, in turn, damaged our economy. The recession is now looping back further straining the financial system as borrowers fall behind on other types of loans — such as credit cards and car loans. It is a vicious cycle.

The Federal government has put in place extraordinary programs to support the financial system. And the economic stimulus package is designed to strengthen our economic fundamentals. We must attack the problem from both directions to break the cycle — and that is exactly what we are doing. The current crisis took years to build up and will take time to work through. I believe we have the right programs in place and as they continue to ramp up, we will continue to see more progress. Our nation will emerge stronger.

Thank you and I look forward to our discussion.

Please visit the Question and Answer portion of Neel Kashkari’s lecture.