Editors' Note: Read Robert Kuttner's update.
One weekend last March, Timothy F. Geithner, president of the Federal Reserve Bank of New York, fielded a panicked phone call from Bear Stearns CEO Alan Schwartz. Bear was nearly out of cash, owing some $80 billion, mostly in short-term loans, to 5,000 firms across Wall Street. Geithner, joined by Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke, had less than 24 hours, before markets opened on the next Monday, to decide whether to advance Bear a $29 billion credit line until a buyout could be arranged--or play roulette with the entire financial system. Geithner ended up taking heat for some details of the rescue, but nearly all observers now conclude that it had to be done.
Four months later, on July 11, Sheila Bair, chair of the Federal Deposit Insurance Corporation (FDIC), acted to close and seize IndyMac, a $32 billion, federally insured mortgage lender that was as much as $8 billion underwater. In taking over IndyMac, Bair used the opportunity to design and test a strategy that she has long urged on the mortgage industry: refinance sub-prime loans at affordable rates, rather than foreclose on the borrower. The model plan, announced Aug. 20, will allow up to 60,000 homeowners to keep their houses and could serve as a template for the broader reform that Bair has championed since the sub-prime crisis began.
Their experiences in the financial crisis have led Geithner and Bair, both non-radical officials with impeccable establishment credentials, to embrace increasingly far-reaching remedies. Both top any list of potential appointees for the next secretary of the treasury--the official who will be responsible for the most drastic financial restructuring since the Great Depression. The treasury secretary is the government's senior economic official--charged with raising revenues, managing the government's finances, overseeing the banking system, and interacting with the Federal Reserve. In calm times, it can be a quiet job. In an economic crisis, treasury secretary becomes a key power position. The list of plausible candidates is short, for the number of people who fully grasp the dimensions of the current crisis, have the competence to deal with it, and enjoy the confidence of both Wall Street and its critics could fit in a phone booth.
A phone booth is not a bad metaphor for Geithner, whose phone rings whenever a big financial firm like Bear Stearns is about to go bust. As president of the most important of the regional Fed banks since November 2003, Geithner has not only had a front-row seat at the most serious financial collapse since the 1930s, he is the key public official who has prevented it from becoming another Great Depression.
The New York Fed has long played a special role at the intersection of government and private finance. Ever since the Federal Reserve System was created by Congress in 1913, the New York Fed has been first among equals. Geithner's predecessor, Bill McDonough, orchestrated the emergency 1998 restructuring of Long Term Capital Management, the hedge fund whose spectacular collapse threatened to take down its leading creditor banks; it was McDonough who made a secret trip to Riyadh in 1990 to arrange for Sheikh Alwaleed bin Talal to bail out a nearly insolvent Citibank. And it is Geithner's staff--not Fed Chairman Ben Bernanke's--that probes the books of the biggest banks. When the Fed decides to intervene in money markets, the New York Fed carries out the policy by buying or selling bonds. And it was Benjamin Strong, president of the New York Fed in the 1920s, who aggressively maintained price levels by buying and selling securities. Had Strong not died in 1928, many scholars think the 1929 stock market crash might not have turned into the Great Depression.
Unlike many senior Treasury and Fed officials, Geithner is not a high roller from a big bank or investment house but a public-minded civil servant. He has neither a doctorate in economics nor an M.B.A. After receiving a master's degree in international economics from Johns Hopkins University, he worked as a research assistant to Henry Kissinger and then joined the Treasury, where he was posted as an assistant attaché in Japan. He came to the attention of both Larry Summers and Robert Rubin and quickly moved up the ladder. He was a key player in the containment of the Asian financial crisis of 1997-1998 and later went to the International Monetary Fund as a top official. Despite being a Democrat, he was named president of the New York Fed after two stronger and more conservative candidates withdrew.
Geithner's admirers span the spectrum from Republican financial mogul Pete Peterson to liberal Democrat Barney Frank. One can infer from his broad fan base three possible conclusions: Wall Street is so clubby and politically powerful that permissible policy differences just aren't that great; or maybe Geithner is all things to all people; or perhaps, in a deep crisis, truly talented and effective people can earn broad respect.
Like Geithner, Bair has mainstream credentials. A Republican Bush appointee to the FDIC, she nonetheless has emerged as the toughest of the several banking regulators in the current financial crisis. She leaned hard on Bush to sign the recent mortgage-refinancing bill and supported an even tougher version. She has been a strong ally of Democrats Barney Frank and Chris Dodd as they push for better banking regulation. Her passion has been promoting the idea that refinancing is preferable to foreclosure. And the IndyMac seizure gave her the chance to field-test this systematic approach.
Her pro-regulation stance is partly institutional. The FDIC is typically among the tougher regulators--because its own insurance funds are at risk when an insured bank plays cute. But Bair also has an interesting personal history. She was a banker from small-town Kansas before becoming a senior staffer to former Sen. Bob Dole. Many small-town bankers display a populist aversion to Wall Street, which often takes advantage of Main Street. Roosevelt's Fed chairman, Marriner Eccles, the only populist ever to head the central bank, was a small-town banker. Rep. Henry Steagall of Alabama, the House sponsor of the landmark Glass-Steagall Act of 1933, championed local banks against the titans of Wall Street.
Bair is in this tradition. If anything, she would likely be an even tougher regulator than Geithner. Like him, she knows Wall Street but is not of it, having served as assistant secretary of the treasury for financial institutions early in the Bush administration, and as acting head of the Commodity Futures Trading Corporation under Bill Clinton. She also did a stint at the New York Stock Exchange.
When a Democratic president takes office, the tradition is to reassure Wall Street by appointing as treasury secretary either a Republican or a Wall Street Democrat. Clinton initially named Lloyd Bentsen, then the financially conservative chair of the Senate Finance Committee. Bentsen was succeeded by Robert Rubin, co-chair of Goldman Sachs--perhaps the ultimate Wall Street Democrat. John F. Kennedy went for the full monty; his treasury secretary was a leading Wall Street Republican, Douglas Dillon of the financial house Dillon Read.
With Bair, Barack Obama would get a fully credentialed and expert Republican--but one who is more progressive on financial regulatory issues than most Democrats. That might appeal nicely to Obama's wish to be simultaneously bipartisan and progressive.
No matter who is appointed, the critical issue going forward is whether the next administration will just keep lurching from bailout to bailout--or whether they will get serious about a New Deal-scale overhaul of the financial system and its standards so that the cycle of speculative bubble and government bailout ceases.
Speaking to the Economic Club of New York last June, Geithner called for a far-tougher regulatory policy to alter "the level and concentration of risk-taking across the financial system." He got quite specific, saying regulators "need to make it much more difficult for institutions with little capital and little supervision to underwrite mortgages." The speech is a blueprint for fundamental overhaul. He has delivered the same message in congressional testimony.
This is also Bair's view. Unlike the New York Fed's ad-hoc rescues, the FDIC operates under a detailed framework when it supervises, examines, and sometimes takes over insured banks when they fail. Like Geithner, Bair has urged an extension of this brand of regulatory authority to financial institutions outside the current structure.
By contrast, Paulson, the current treasury secretary, has called for broad general oversight by the Federal Reserve, with ad-hoc interventions as necessary. According to an official who has been privy to these debates, "Paulson's approach is a joke. The Fed has now extended the safety net to investment banks, private equity firms, and hedge funds. The real question is what kind of detailed public supervision will there be in exchange for these public benefits."
In the crisis management over the past year, Geithner has worked closely with Paulson. And Bair has emerged as a formidable player in the policy discussions of Paulson's senior working group. But their contrasting views of the system's architecture going forward define the axis of the core policy debate that the next administration must resolve.
The views of Geithner and Bair have increasingly converged with those of the key Democratic banking legislators. As Rep. Frank told me, "Supervision of commercial banks today is pretty good. The problem is that other players like investment banks, hedge funds, and private equity companies do many of the same things banks do and can put the whole system at risk. So they need the same degree of regulation. And examiners need both access to their books, and the ability both to ask further questions and to say, Stop."
That would be a revolutionary shift in the way government regulates investment bankers, private equity firms, and hedge funds, none of which have been subject to scrutiny of their books or their capital positions (except after the fact in cases of fraud or crisis). But Barack Obama has said much the same thing. "We need to regulate institutions for what they do, not what they are," he said in a radically reformist speech last March in New York.
When Franklin Roosevelt had to rebuild a ravaged financial system in 1933, he could draw from hundreds of knowledgeable veterans of the Progressive Era. Roosevelt's adviser and later Supreme Court Justice Felix Frankfurter could reach into his Harvard Law School network and send Roosevelt legions of "Frankfurter's Happy Hot Dogs," the young prodigies who designed the modern system of financial regulation. Ever since the crash of 1929, serious people had been intensely debating details of just how to tame the monster of speculative finance, and they had concrete ideas.
Today, however, the likes of Geithner and Bair are few. The legacy of 30 years of deregulation has done damage not just to the markets but to the ranks of financial experts who embrace regulation. In 2009 we will need landmark reform legislation on the scale of the great Roosevelt-era laws that redefined the structure of the banking system and established ground rules for commercial and investment banks, securities brokers, and stock exchanges. The challenges are both philosophical--what should be regulated and why--and institutional--which agencies of government should be charged with what responsibilities. Because the pervasive ideology of deregulation has lately been disgraced by events, it is only now that these questions are being asked seriously.
As Geithner, Bair, and Obama have each suggested, all financial institutions with the potential to infect the system and trigger government bailouts need far more extensive supervision and examination, as well as capital, leverage, and liquidity requirements. This would be a first for investment banks, hedge funds, and private equity firms. But these enterprises now engage in the same business activities as regulated banks, and they all infect each other. Last year, according to Frank, 60 percent of all credit in the United States was created by financial institutions other than banks, many of them almost entirely unregulated and unexamined. If an institution quacks like a bank, incurs risk like a bank, and gets bailed out like a bank, then it needs to be regulated like a bank.
In addition, some practices are so dangerous to the system that they need to be prohibited outright. These include the conflicts of interest between stock brokers and their customers, the flagrant hazards built into the bond-rating system, as well as abuses of short-selling. The landmark legislation will also need to fix the current patchwork of overlapping and underperforming government agencies.
If John McCain is elected, he might turn to a far more reckless financial type than Tim Geithner or Sheila Bair. Some have touted former Sen. Phil Gramm as a McCain treasury secretary. Gramm, more than any other senator, was responsible for the regulatory dismantling. Appointing Gramm would almost guarantee another Great Depression.
Even if Obama is elected, there will be immense political pressures not to appoint tough regulators or enact tough regulation, and we could end up with a weaker leader than Geithner or Bair. Whether hawk, pussycat, or fox in the chicken coop, the next treasury secretary will only be as effective as the next president allows.
Other plausible contenders for the job
Jon Corzine, governor of New Jersey. Corzine is by far the most progressive of the Goldman Sachs senior alums who have colonized Washington, who include Rubin, Paulson, and former Bush top economic adviser Steve Friedman. Goldman is the rare firm that has not suffered from the financial collapse, but most of its graduates have concluded that the remedy is smarter people just like themselves, not better rules. By contrast, Corzine believes in tougher regulation.
Liability: A free spirit; a bit hard to imagine him as an Obama team player.
Daniel Tarullo, Obama's top adviser on financial issues. After Obama's remarkably detailed and assertive Cooper Union speech, people wondered where it came from. The candidate evidently spoke to a range of people that included former Fed chairman Paul Volcker and super-investor Warren Buffett. But my reporting points to Tarullo as a key influence. A law professor at Georgetown and former senior Clinton official on international economic policy, Tarullo is probably the most progressive senior economic adviser to Obama.
Liability: Perhaps not quite enough Wall Street experience to be secretary, but could be the key sub-Cabinet or White House player in the reform design.
Roger Altman, deputy secretary of the treasury in the first Clinton administration. In normal times, Altman would be a front-runner. In addition to two sub-Cabinet posts at the Treasury, he's worked at Lehman Brothers, the Blackstone Group, and is now chairman of his own private-equity boutique. The quintessential Wall Street Democrat, Altman was a big Hillary Clinton backer.
Liability: A major supporter of the deregulation that got Wall Street into this mess.
Epilogue: Since this article went to press, Geithner, Bair, Paulson and Bernanke found themselves at the center of an even deeper financial crisis, triggered by another large failure--the collapse of the venerable firm Lehman Brothers. In that failed rescue effort, it was Geithner once again who was on the front lines. Working over the weekend of September 13, Geithner called together the heads of Wall Street’s biggest firms as he had done in the JP Morgan Chase - Bear Stearns deal that was guaranteed by the government. But this time he and made it clear that any salvage of Lehman would have to be done by the private sector. There would be no government bailout or guarantee.
By Monday, Lehman went down. The decision to let Lehman go was made jointly by the Federal Reserve and the Treasury Department, as Paulson tried to draw a line in the sand against further government-underwritten rescues. But the sands shifted when the collapse of Lehman sent tremors first through the world’s largest insurance company A.I.G, and then through iconic Merrill Lynch. The administration and the Fed ended up promoting a fire sale of Merrill to Bank of America—and buying most of A.I.G. for $85 billion of taxpayer money.
At that point, panicky markets began seizing up; the Fed’s own funds were more than two-thirds tied up in ad hoc rescues; and Democrats began calling for a more systematic approach. Paulson hurriedly drew up plans to ask Congress for $700 billion to buy up toxic assets that were now threatening to take down the entire system. The Dow, which had lost more than a thousand points, rallied on the news. Had Lehman hung in for another week, the government might have relieved the firm of a lot of its bad investments in the context of a general rescue, and Lehman would have survived. So it goes.
Bair, meanwhile, was operating Indy Mac, the failed bank seized by the FDIC, in a manner opposite from that of the Paulson plan. Instead of buying bad paper from the bank and letting incumbent management, she seized the bank, tossed out the culprits, and ran the institution in the public interest, offering refinancing to tens of thousands of holders of extortionate mortgages.
At this writing, Congress seems very likely to enact some version of the Paulson plan. But it remains to be seen what conditions Democrats will attach. Paulson is adamantly opposed to any form of re-regulation until the immediate crisis is stabilized, and it is not possible to write comprehensive regulatory legislation in a few days. The next design for regulating the financial system will fall to the new administration—to be led by Geithner, Bair, or someone of like mind.
The best thing the new president could do would be to appoint a task force of experts committed to re-regulation of finance. When Henry Paulson took office in 2006, he worked closely with an industry-sponsored task force that was making the case for deeper deregulation. Here is a proposed task force of senior, credible financial experts of the opposite persuasion. The order is alphabetical:
A Task Force on Rebuilding a Secure Financial System
Rawi Abdelal, Harvard Business School, author, Capital Rules
Phil Angelides, former California state treasurer
Sheila Bair, chair, FDIC
Richard Blumenthal, attorney general of Connecticut
Jack Bogle, founder of Vanguard Mutual funds
Richard Bookstaber, former risk manager, author of A Demon of Our Own Design
Warren Buffett, super-investor
Jon Corzine, governor of New Jersey, former CEO of Goldman Sachs
James D Cox, Duke University law professor, expert on securities regulation
Eric Dinallo, New York State Insurance commissioner
William Donaldson, former chair, SEC
Barney Frank, chair, House Banking Committee
Timothy Geithner, president, Federal Reserve Bank of New York
Harvey Goldschmid, Columbia Law School, former commissioner, SEC
Bill Gross, chief executive of PIMCO
Martin Gruenberg, vice-chair, FDIC, former chief of staff, Senate Banking Committee
Robert Johnson, investment banker, former staff, Senate Banking Committee
Lance Lindblom, president, Nathan Cummings Foundation, former financial executive
David Moss, Harvard Business School, author, When All Else Fails, and convenor of the Tobin Project on Regulation
Nouriel Roubini, professor, NYU Stern Business School
Paul Sarbanes, former chair, Senate Banking Committee
Joel Seligman, president, University of Rochester, securities law scholar and historian, author, The Transformation of Wall Street
David Smith, chief economist, House Financial Services Committee
Jim Stone, former chair, Commodity Futures Trading Commission
Daniel Tarullo, Obama senior adviser on financial markets