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We have come to a major crossroads in the history of our nation, a time when you must understand all the relevant events in far greater depth, and see the likely future with far greater clarity.
Indeed, I feel this need is so critical and urgent, I am providing you this morning with the most elaborate gala issue in the history of Money and Markets.
Let’s begin by assuming that, despite all the government bailouts, many of America’s largest corporations still go bankrupt, U.S. unemployment continues to surge, and a new, larger wave of home foreclosures sweeps the nation.
How will our leaders respond?
I have no pretense of knowing the answers. Nor can anyone forecast what individuals in power will decide under the stress of pending doom. But following up on a similar fictional scenario that I drew for you many months ago, here’s what I see ahead …
The Final Bailout
The time is sometime in the future; the venue, a hastily assembled meeting at the White House.
The President’s Chief of Staff invites the Treasury Secretary, the Federal Reserve Chairman, the CEOs of bankrupt or at-risk corporations, and former Federal Reserve Chairman Paul Volcker. The Treasury Secretary obtains unanimous vows of confidentiality and opens the discussion.
Treasury Secretary: Gentlemen, I know the events swirling around us seem like Armageddon. But let’s begin by stressing the positive: Not all banks have failed. Not all big companies have gone down. The financial markets, even after their great decline, are still alive.
The grave challenge we face is that — despite the trillions we’ve spent, lent, invested or guaranteed — we have not yet been able to restore confidence. So our goal is to come up with a revolutionary new set of actions that meet the challenge.
But first, I want to get everyone’s views and stress the importance of coordinated communication. In normal times, I wouldn’t presume to tell you what to say or how to say it. But in this unsettling climate, the last thing we need is dissenting voices from the administration, from former government officials or even from industry. We must present a united message that resonates, that’s credible, that can inspire consumers to consume, investors to invest, lenders to lend.
Chief of Staff: First, I want to apologize for the President’s absence; he is dealing with another financial emergency that we will also have to address, at least briefly, before the end of this meeting. It was too late to combine that meeting with this one.
Treasury Secretary: I’m joining them as soon as we’re finished here.
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Chief of Staff: Yes, I am also. Second, although many of us are already familiar with it, let me remind everyone of the President’s strategy regarding messaging: Get the bad news out into the open right up front. Don’t sugarcoat it. Then segue very quickly to the positive — what steps we’re taking, what we believe the outcome will be.
What he wanted me to ask you is: What economic pressures are driving this phase of the crisis? What’s at its core?
Fed Chairman: At the core of the crisis are two forces feeding on each other — (a) debt liquidation and (b) price deflation. Although we saw them coming and although we had contingency plans in place to deal with them, what caught us flatfooted was their volume and, above all, their speed.
The debt liquidations — in every credit sector — have struck so quickly, they have overwhelmed our efforts to restore credit creation. The price deflation — impacting a gamut of goods and services — has been so dramatic, it has neutralized our rate cuts, money infusions and other stimulus measures.
Let me refer you to Chairman Greenspan’s memorable comments regarding this crisis.
Chief of Staff: His testimony before the last Congress.
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Fed Chairman: Yes. About the tsunami; about the once-in-a-century crisis we were facing. Well, let me tell you what I’m hearing now — from some of my staff and from other hushed voices. What I’m hearing is that, with the events that have unfolded since then, this is not a 100-year storm for the American economy; it’s a millennial rite of passage for all mankind.
Treasury Secretary: Millennial?
Fed Chairman: I didn’t say I agree with that. I merely said that’s what’s being said.
Treasury Secretary: I accept the 100-year storm concept. But let’s not get carried away by the public mood of gloom. Yes, I know debt liquidation and price deflation continue to be at the heart of our economic challenges and remain our most significant downside risk. I know real estate prices are down as much as 50% in some sectors and stock market barometers are down nearly 70% from their former peaks. And I know all about the tsunami of home foreclosures.
But let’s also give people hope, damn it! Let’s not do like some people — I won’t mention names — who talk about the housing market as a “bottomless pit” … or the automotive industry as a “black hole” … or Wall Street like “ground zero of a neutron bomb.” Let’s not talk about a run on bank deposits or insurance policy loans. And for God’s sake, let’s not name names of banks on the verge of insolvency!
Fed Chairman: None of those statements were mine. But from everything I can see, they may not be that far from the truth. So I’m pleased that Citigroup and JPMorgan have accepted our invitation to join us today.
I’d like to take this opportunity to ask Citigroup about its credit card and consumer loan portfolios. Is it true that, if you value them properly, the bank is, in effect, insolvent? And I’d like to ask JPMorgan a similar question: If you value your derivatives based on actual, current market conditions, is there truth to the view that Morgan is also de-facto insolvent?
Before you answer, let me stress that the Federal Reserve, in coordination with central banks globally, has done everything in its power to avert this situation, and with some success. We were able to revive the short-term interbank lending market. We were able to stave off a calamity in the commercial paper market. We were even able to restore some sectors of the consumer credit market.
But it was — and still is — obviously impossible to maintain adequate activity levels in all credit sectors on a continuing basis, due simply to the confidence factor the Secretary stressed at the outset. If borrowers are reluctant to borrow and lenders are afraid to lend, there’s only so much we can do. How do we twist the arms of millions of consumers and thousands of banks? We can’t. That’s why, ultimately, in the final reckoning, every credit stimulus we’ve tried has failed its primary objective — the restoration of confidence.
Citigroup: If this is the day of reckoning, and this is the time to start confessing, I will be the first to volunteer. I can no longer stand here before you and refute the fact that Citigroup is effectively insolvent.
Treasury Secretary: I, ah, I … I find that hard to believe.
Citigroup: At our peak, we had 185.1 million in credit card accounts, with 147 million of those in North America. Peak value: $200.7 billion. Now, more than a quarter of that entire portfolio is impaired — over 90 days past due or in default. God knows we’ve tried everything in our power to hold back that tide. But we could not act fast enough. And where we erred, I believe, is actually doing too much to ease the crisis.
Fed Chairman: In what sense?
Citigroup: Under pressure from the administration, we gave slow credit card payers more time. With subsidies from Congress, we then reduced their liabilities. But what message did that send? It merely sent the message to all nondelinquent accounts that the only way to qualify for aid was to become delinquent. It rewarded bad financial behavior. It promoted delinquency. In the end, nearly all of the steps we took to ease the burden for consumers inadvertently increased their burden.
Treasury Secretary: But what other choice did we have?
Citigroup: Tough love. Instead of a haphazard pattern of government-induced laxity here and industry-enforced toughness there; instead of giving some debtors a break, while forcing others into personal bankruptcy; instead of a mixed message that created confusion, we should have all been on the same page together — even-handedly tough across the board.
Treasury Secretary: That would have been totally inconsistent with the goals of this administration.
Citigroup: Let’s be honest here; let’s face up to the truth. Debts are debts; charity is charity. Instead of pouring good taxpayer money after bad into delinquent credit cards, why don’t we just set aside a fraction of that money for organizations dedicated to recovering debt addicts? I can’t guarantee it will work. But I can guarantee it will be a heck of a lot cheaper, without the boomerang effect.
Treasury Secretary: Which was …
Citigroup: The fact that we made it easier for more people to fall behind on their credit card payments. So guess what! More people fell behind — far more than they would have done otherwise, according to our surveys.
Fannie Mae: I must confess this was the same message we gave to the indebted homeowners of America: “To qualify for government debt relief,” we said, “you have to be delinquent. If you’re cutting your food budget, if you’re pawning your wedding rings, and if you’re doing all that to stay current with your mortgage payments, you don’t qualify. Sorry, no mortgage relief for you!” And that was supposed to be our way of cleaning up this mess?!
Now, look at the numbers that just came out! You’ve got a new, larger wave of Americans walking away from their mortgages and abandoning their homes with little sign of remorse.
Treasury Secretary: I know. It’s very ugly.
Fannie Mae: Yes. But what has us truly dismayed is the fact that, in the vanguard of that trend, there are some of the very same groups which, in an earlier stage of their payment history, were identified as the categories most qualified for mortgage relief. Instead of lightening their debt burdens, we merely prolonged them; instead of countering the culture of default, we merely enhanced it.
Treasury Secretary: Can we get back to the situation at Citi?
Citigroup: Yes. The tie-in to our consumer loan division is that the housing disaster feeds on the credit card disaster. We saw this coming. That’s why, quite some time ago, we warned investors that credit-related losses, such as payouts on loans we guarantee, were going to rise for the foreseeable future. But then the market crumbled far faster than anyone dreamed possible. Even the Jeremiahs and Cassandras inside Citigroup — and believe me, there are more of them coming out of the woodwork every day — even they underestimated how fast the consumer credit market could come unglued; how fast credit cards, auto loans, and student loans would go sour. That’s why some Wall Street analysts are saying, rightfully so, that we may not have enough capital to offset those losses.
Treasury Secretary: Why, then, do your statements show that you have adequate capital? Even the Comptroller of the Currency has testified before Congress that you have adequate capital. What are they looking at?
Citigroup: Outdated data. Even we are looking at outdated data. Things are happening so fast, by the time we get credit card and other consumer delinquency data compiled, it’s as if a whole year has gone by, compared to what would have been the typical data lag in more stable times. So we have to estimate what’s actually happening in real time. But even without taking those projections into consideration, we’re still coming up short on most capital measures. The big picture is simple: Asset values are plunging all over the country. Consequently, our asset values are plunging in tandem. That’s it in a nutshell.
Fannie Mae: Our situation is similar. We get reports from 5,000 real estate brokers all over the country handling our foreclosure sales. And out of those reports, we pulled one for a case study — in Flint, Michigan. The broker was trying to sell a particular home for a price that will shock you.
Citigroup: Under $30,000 or so?
Fannie Mae: Way less than that! He first tried to sell it for $6,900, but had no takers. Then he cut the price to $5,000, and still no buyers. This was a three-bedroom home in a residential neighborhood we’re talking about — not a two-door Chevy on a used car lot!
My point is that we were not picking up this type of thing in our databases, due to the same kind of data lag Citigroup is experiencing.
Meanwhile, new foreclosures are off the charts. Just last quarter, we got saddled with four times the number of homes through foreclosure than we could sell. We’ve tried to get rid of them quickly. But we keep falling further and further behind.
General Motors: You talk about home price deflation. But auto price deflation is equally severe. At the end of a two-year lease, one of our most popular SUVs was supposed to be worth $22,000. As it turns out, the best price we can get for it in the used car market is less than $4,000. And we’re not the only ones. I had my staff give me a list of other auto products and services that have suffered the worst declines — it’s a mile long.
Treasury Secretary: What about wages?
General Motors: The minimum wage is a joke. I haven’t seen this at GM particularly. But nearly everywhere else, workers and their employers are finding ways to get around the minimum wage. They’re working double time or clocking in for half-time hours. They’re busting labor laws and union rules, and the authorities are looking the other way. In other words, deflation is destroying our country. The Fed must inflate us out of this — with rate cuts and more.
Fed Chairman: I appreciate that. But I’d like to keep this focused on the GSEs for now. How much do Fannie and Freddie have in foreclosed homes on their books?
Fannie Mae: I don’t have exact Freddie Mac figures. But, roughly speaking, at the last reckoning, over $40 billion worth. Right now, probably more.
Fed Chairman: That’s a lot, but in proportion to the $5 trillion-plus in mortgages that you and Freddie own or guarantee, it doesn’t sound like that much to me.
Fannie Mae: The $40 billion is just the foreclosed properties we currently have in inventory, which are just a small fraction of the properties we’ve already cleared out … and, unfortunately, which are an even smaller fraction of the foreclosed homes we see coming down the pike.
We’re at the center of this mess. Right now, there are 8,500 banks and thrifts in this country holding about $60 billion in foreclosed homes. But between Fannie and Freddie — just two companies — we’re stuck with at least $40 billion. So if you look at all the money tied up in foreclosed homes in the United States, you’ll see that more than $4 of every $10 is our burden.
Fed Chairman: What are you doing about it?
Fannie Mae: Until last year, our stated goal has been to always seek the highest possible price for our foreclosed properties, even if that meant hanging on to them longer. But with the huge backlog we now have, that approach is no longer viable. Now, we’re pricing our foreclosed properties a lot more aggressively.
Trouble is, once we sent a directive to our 5,000 brokers across the country — to broaden some auction parameters and remove certain restrictions — there was no way we could keep that directive under wraps. Everyone in the local markets heard about it, and since we’re such a big player, nearly everyone is following our lead, dumping properties virtually regardless of price.
Treasury Secretary: Could it be that you are overstating the price declines and the losses that they have caused? Take that house in Michigan, for example. It must have been a dump to begin with. Do you know how much it sold for originally?
Fannie Mae: It’s a dump all right. It needs a new roof. It needs new carpeting. The plumbing has been ripped out. But back during the peak of the housing boom, it was not a dump. Back then, it sold for $110,000. So even assuming we can find a buyer for $5,000, its price has fallen by over 95%. Naturally, most of our foreclosed homes for sale haven’t fallen that far, that fast. But this gives you an anecdotal illustration of what we’re up against. And it gives you a sneak preview of the much deeper home price declines that are possible in the future, especially when entire neighborhoods are blighted, which is now becoming far more common, even in some higher end communities.
Treasury Secretary: But how widespread is this, really?
Fannie Mae: What definition are we using for “widespread”? If I told you that among the supposedly “AAA” rated subprime mortgage securities issued in 2006, the default rate is now about 98%, would that qualify as widespread?
Treasury Secretary: Ninety-eight percent?
Fannie Mae: You shouldn’t be so surprised. In 2008, it was already not far from current levels — 86%. And I’m not referring to a small, little subset of our portfolio. At our peak, we had about $70 billion in subprime and Alt-A securities in our portfolio. Freddie Mac was even more at risk, with nearly $150 billion. And that’s not even our primary concern any more. As you well know, our primary concern is the surging foreclosure rate in prime, supposedly high-quality mortgages, which represent the bulk of the paper we hold or guarantee.
Treasury Secretary: What is your outlook for nonperformance of prime mortgages going forward?
Fannie Mae: We used to say this crisis was “contained” to one sector or another. But that idea fell by the wayside in 2008. More recently, our view has been that it’s so bad, it can’t get any worse. But we can’t maintain that fiction much longer either. The fact is, we have no way of estimating how high delinquency rates can go on prime mortgages. Just a few years ago, who would have dreamed that the subprime delinquency rate could ever exceed 20%? Now look! Nearing 100%!
What we have to do now is learn from that mistake: To make no more promises. To tell the public what’s going on. As bluntly and clearly as we can.
Treasury Secretary: Why now and why so bluntly?
Fannie Mae: One reason is that, until recently, the rating agencies were playing along with us on this, postponing downgrades, keeping the fantasy alive. But now they’re downgrading all of this mortgage paper to deep junk levels in one fell swoop. They’re forcing everyone — including all of us here around this table — to face reality. Wall Street is telling us that, until we face reality, this crisis is going to be an endless soap opera. Another reason is that we’re soon going to run out of the $100 billion federal bailout money that Congress committed to Fannie Mae, and we’re going to have to explain to Congress why we need more.
General Motors: I think it will add value if I can contribute our experience to this discussion. Like Fannie Mae, we’ve also been through the ringer on this already — along a different path perhaps, but with a similar end game. At yearend 2008, as you will recall, the debate was whether or not to bail out GM with taxpayer money or let us file for Chapter 11.
Treasury Secretary: During the transition between administrations.
General Motors: Right. Looking back, however, we can see that the debate was splitting hairs. With a federal bailout, the conditions were to make massive cuts to turn the company around. And with a Chapter 11 filing, the mandate was also to make massive cuts to turn the company around. Six of one; half a dozen of the other. The only aspects that seemed to differentiate those two scenarios were the timing — a bit sooner or a bit later — plus the name on the door. It was going to be either someone appointed by the bankruptcy court if we filed for bankruptcy or a Treasury-chosen auto czar if we got the bailout.
At the time we wanted the bailout, of course. But looking back, I can see we would have wound up essentially in the same place we’re at right now — a shell of our former self, the epicenter of a jobless nightmare.
Treasury Secretary: From what I recall, though, there was heightened concern about a bankruptcy’s impact on shareholder value and on customer loyalty.
General Motors: That was our argument, yes. But in retrospect, we can see that was a classic case of shutting the barn door after the horse is gone. Shareholders were already practically wiped out, with only pennies left on the dollar. Customer loyalty and sales were already shot to hell, due to the bankruptcy chatter on the Internet and in the media. This is not like the old days when public messaging was about “divide and conquer,” telling one group one thing and another group something else.
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Paul Volcker: Gentlemen, I’ve been listening to this discussion patiently, and I think the time has finally come for me to stop pulling punches and to put all my cards on the table.
First, although we started this meeting focusing on how to control messaging, the actual discussion which has evolved has been driving us to confessional. I heard Citigroup use that word. I heard Fannie Mae do it as well. And there was mention of the same refrain coming from Wall Street sources. So this meeting, under the cloak of confidentiality, is already a collective confessional. Now it’s time to shed the cloak and make it a public event.
Don’t be overly concerned with the impact on markets. As was also said, and correctly so, they are already in a state of chronic panic. Taking the lead on that front will help restore trust in our leadership and, later, in the economy.
Chief of Staff: You want the administration to be the leading source of any new bad news. You want us, in effect, to regain control of the news cycle. Is that it? If so, I see the wisdom in that. But …
Treasury Secretary: But what is the reaction going to be in the markets?
Volcker: It’s going to be cathartic. It could trigger a final, climactic wave of selling. They call it “capitulation” — when investors dump whatever they’ve been planning to sell all along; when they sell out with little regard to price.
Fannie Mae: Much like I was saying earlier regarding the recent trends in foreclosure sales.
Volcker: Yes. Not just in real estate and stocks, but also commercial paper and corporate bonds; not just marketable assets but also business inventories and receivables, consumer collectibles and valuables. It’s already happening. So we must be prepared for the possibility that, once we take the action I’m going to propose, a lot of that material still in the hands of nervous sellers is going to be flushed out.
Treasury Secretary: I’m having great difficulty buying into this.
Volcker: I suspected you would be, and when you hear the other side of my proposal, the more substantive side, I expect you’re going to be even more opposed. But if we don’t do it, I fear you’ll be forever …
Chief of Staff: … playing whack-a-mole.
Volcker: What?
Chief of Staff: Putting out brush fires.
Volcker: Right. Let’s review, one last time, what has happened and what we have done. For many decades, we have progressively built up a massive pool of private and public debts; and we did so while continually diminishing the savings that typically are required by modern economies to underpin such debts. After World War II, that’s the situation each successive administration has inherited, greatly enlarged, and then passed on to the next administration. And that’s why each administration has sought to build — with government guarantees, bailouts and backstops — a larger and larger dike to guard against any debt collapse.
In 2008, however, we came to the end of the line. The debt quality was so poor and the quantity so large that toxic paper began to spill over into the real economy. The dike sprang larger and larger leaks. And in response, all we thought of doing was to plug them with taxpayer money. First, subprime mortgages; then prime mortgages … the interbank market … commercial paper … consumer credit. First, Bear Stearns; then Lehman and AIG … Fannie Mae and Freddie Mac … Washington Mutual and Wachovia … GM and Ford … and now even Citi and Morgan. Each bigger than the previous, each taking us closer to the threshold of the absurd.
We dare not cross that threshold; we must change course. Now, rather than plugging the leaks reactively, we must guide and divert the flood waters proactively.
Treasury Secretary: Can you translate these metaphors into policy?
Volcker: It’s precisely what Citigroup was saying for credit cards, but writ large: Tough love — for debtors and lenders.
I’ve dug up some old, rarely-cited sources about the banking crisis during the 1930s, and having devoted many a sleepless night to their study, I now see things quite differently from virtually everyone in this group. We used to believe that, after the Crash of ’29, the Fed’s hands-off approach either played a pivotal role in causing the Great Depression or at least made it a lot worse than it would have been otherwise. From that, we not only concluded that the Great Depression could have been prevented, but we also derived the theory that all depressions — present and future — were preventable.
You’ve heard this quote from Mark Twain, I’m sure, but let me recite it for you anyway. “When I was a boy of 14, my father was so ignorant I could hardly stand to have the old man around. But when I got to be 21, I was astonished at how much the old man had learned in seven years." Similarly, over the past months, the more we have floundered from bailout to bailout, the more I have realized how we underestimated the intelligence of our Fed forefathers. Men like Roy A. Young, Eugene I. Meyer, Eugene R. Black and others who presided over the worst of times in the 1930s.
Back then, there was also an attempt to patch banks up and sweep bad assets under the rug — not nearly as much as today, of course, but in the context of those times, a very significant effort nonetheless. Then, they too changed course, much like we will have to sooner or later.
Instead of propping up bad banks, they proactively shut them down. Instead of shotgun mergers to move toxic paper from weak banks to strong banks, they segregated the good assets and quarantined the bad ones. When that wasn’t enough, they shut the banks down in statewide holidays. And when that still wasn’t enough, Roosevelt shut them all down in a national holiday.
It wasn’t planned ahead of time; they also had to react to unexpected events, especially bank runs. But they eventually responded with an army of tough bank examiners. Unless banks could pass a tough exam, they were not allowed to reopen. It was banking triage en masse. Bad banks — shut down forever. Good banks — reopened promptly. On-the-fence banks — not for many months.
Treasury Secretary: Didn’t that deepen the Depression?
Volcker: Yes, it probably did. But the deepening effect would have happened anyhow, albeit in a more haphazard fashion. Moreover, without the bank closings and debt liquidations of those years, the subsequent recovery — including possibly the 60-year growth between 1946 and 2006 — could have been anemic. Indeed, depending on the vagaries of history and the rise of competing powers, much of that growth may never even have happened.
Treasury Secretary: So is that what you’re advocating? Proactively shutting down major banks that don’t meet your elevated standards?
Volcker: That’s what they did. What we must do is adapt that experience to the current realities.
Treasury Secretary: Such as?
Volcker: Such as the big risk areas that did not exist then. We need immediate data on derivatives portfolios and their true valuation. We need detail-level intelligence on the current credit exposure of derivatives players and the true risk of counterparty default. We need higher standards for risk-based capital to back it and efficient enforcement of those standards.
Treasury Secretary: I see the problem. Who doesn’t? What I don’t see coming from you today is a solution other than a defeatist one. You yourself used the word capitulation. That’s not a solution. It’s surrender.
Volcker: Retreat? Yes. Surrender? No!
Look. We’re fighting the wrong war — against debt liquidation and price deflation.
It’s the wrong war because we’re losing. And it’s the wrong war because debt liquidation and price deflation are the economy’s natural mechanisms for cleansing itself — a process we need to manage proactively.
Treasury Secretary: Please explain.
Volcker: What were — and still are — the great, insurmountable, intractable problems of our economy? They were (a) excess debt and (b) high prices, making homes unaffordable, hampering education, making it impossible for our workers to compete internationally. Now, with this crisis, all that is naturally being flushed out and reversed. Debts are being liquidated. Prices are falling. American workers are suddenly willing — even anxious — to work more for less.
Granted, this cleansing process is progressing far too quickly and too traumatically. We must cool down its feverish pace. But that’s all part of managing the crisis.
Treasury Secretary: OK. Suppose we retreat. What then is the new battle line?
Volcker: The war we can win, and do so inexpensively.
Treasury Secretary: Against foreign competition?
Volcker: That too, but that’s not our first priority. Our first priority is right here at a home — to ready ourselves for the battle that is now being fought on a secondary plane, sometimes neglected entirely.
Treasury Secretary: Which is …
Volcker: Think ahead. Connect the dots. Three hundred million people. Banking system in shambles. No jobs. No money.
Citigroup: We’re all a bit perplexed here. What are you getting at?
Volcker: It’s staring us in the face. It’s the hidden underbelly of this crisis. We’ve been so intensely focused on saving the big institutions, we’ve failed to anticipate the magnitude of the human tragedy ahead — let alone make the needed preparations.
Citigroup: I believe he’s talking about unemployment.
Volcker: No one can predict exact numbers. But imagine temporary periods of on-again-off-again industrial shutdowns — periods when fewer people are on the job than out of work. Not necessarily on a national basis, but certainly in blighted industrial regions like Michigan. Imagine 20% or 30% unemployment nationwide; bread lines and soup kitchens for the hungry; tent cities for the homeless. And that’s assuming we do take the urgently needed steps to prepare ahead of time. If we do not prepare, consider the real possibility of mass migrations of the middle class, starvation of the poor, pandemics of diseases that are eminently curable.
Chief of Staff: I mean no disrespect. But is this your idea of a made-for-TV documentary? On the History Channel or the Sci-Fi station?
Volcker: Neither. It’s the real thing, and I have the stats to prove it. It’s Katrina-like conditions in all major metropolitan areas, including large segments of the middle class. Except it’s caused by financial storms — the kind that can make natural storms and civil wars seem small by comparison. I am not predicting this. I just want to open everyone’s eyes to the ultimate consequences of complacency in the wake of a massive economic disaster.
Treasury Secretary: Don’t we already have depression-era institutions to handle all that?
Volcker: In name only. They’re grossly outdated, underfunded and understaffed. But even the most ambitious relief efforts are going to be far less expensive than the least ambitious financial bailouts. We have the surpluses. We have the technology and the know-how. That’s the battle we can easily win. But if neglected, it’s also the battle we could easily lose, like Katrina.
Treasury Secretary: So you win the battle against hunger and sickness. You create a super welfare state. And at the same time, you lose the battle for the private economy. This sounds like a socialistic dead end to me.
Volcker: No more so than protecting New Orleans from a second Katrina! No more so than protecting the homeland from foreign attacks! And I never said we’d give up the battle for the economy. What I said was that we would manage the economic crisis more rationally. Once a substantial portion of the bad debts are liquidated, once the deflationary forces are mostly exhausted, then we can pour more money into stimulating a recovery.
Never forget: The U.S. government is the largest single investor in the entire economy. So you must think like a big investor, like a Warren Buffett or a George Soros. Do you buy near the top, when your buying power is overwhelmed by selling, when your capital is chewed up to pieces? Or do you apply your buying power nearer to the bottom, when your capital is far more effective?
Right now, we are already powerless to stop the decline anyhow. We have already cut rates to practically zero. But that didn’t do the trick. We rushed out the biggest bailout packages of any government at any time in history. But that didn’t do the trick either. And now look! Citi and Morgan. Technically insolvent.
My recommendation: Wait for the right time. Then buy.
Treasury Secretary: Buy what?
Volcker: The surviving companies that have the best solutions for our society. Give them the access to innovative technology and talent. Give them the low interest loans, if needed. Give them the capital infusions if you must. Not the white elephants of a bygone era!
Treasury Secretary: I cannot accept this defeatism. I will never accept it. We must do whatever it takes to keep the credit flowing. I don’t care what you call them — bankrupt or not bankrupt, solvent or insolvent. We must do whatever it takes to keep them fully capitalized. That’s the case we must make before Congress again and again … until we lick this.
Volcker: I beg to disagree.
Treasury Secretary: Then what do you propose?
Volcker: Before I build up to a proposal, I want to lay down the foundation with a basic principle. Ultimately, the fork in the road ahead is between (a) deflation and depression or (b) hyperinflation and destruction of our currency. But there can be no debate whatsoever as to which is the lesser of the evils.
The deflation road is extremely arduous, but ultimately leads to recovery. The hyperinflation road can provide a temporary palliative, but it ultimately leads to the destruction of our society and culture.
Treasury Secretary: Was it not the deflation of the 1930s that led to World War II?
Volcker: No. The true roots of World War II lie in the hyperinflation of Germany in the 1920s. But let’s not debate history. Let’s look at our choices here and now …
Choice number one: A strong currency — the nation’s social and political anchor. It gives workers a reason to work and be team players; families a reason to save and come together; entrepreneurs a motive for innovating.
Choice number two: A failed currency — a nation’s albatross. It gives speculators, market manipulators, scam artists and the worst criminal elements the upper hand — not just on the sidelines of power, but in the upper echelons of government and enterprise.
Treasury Secretary: Please give us your proposal.
Volcker: Step number one: Tell it like it is, the bad news we discussed earlier.
Step number two: Make a solemn vow to the public that the government will set the standards, enforce the law, help ensure fairness, and provide emergency aid to the sick, hungry or homeless.
Step number three: Tell the American people that the government can no longer be the lender, spender and investor of last resort. Leave no doubt that, going forward, the U.S. government is exiting the bailout business.
Step number four: Make it absolutely clear that it is now time for all citizens to step up and make the needed collective sacrifices to save our country.
Step number five: Take immediate action to stop the cancer that is now threatening to tear down our country.
Treasury Secretary: I thought you said we should exit the bailout business.
Volcker: This is the last bailout, the primary topic of the other emergency meeting which some of us must now join. But if we have just 10 more minutes, I can give you a thumbnail sketch of what the emergency involves. It involves the fact that the major government security dealers are having serious difficulties placing U.S. government bonds for sale.
The truly dangerous cancer that’s spreading in the world today is the cancer of mistrust. First, it was mistrust in subprime mortgages. Then, mistrust in higher quality mortgages. Next, mistrust in Fannie Mae and Freddie Mac. Then, mistrust in almost every private financial institution in the world.
Let me fast-forward now to the final, fatal stage of this cancer, the stage we are coming to soon. It is mistrust in the U.S. government itself, the phase when investors all over the world no longer trust the debt of the United States Treasury Department.
Gentlemen, I know this monster well. I looked it squarely in the eyes decades ago. In those days, we did not have collapsing financial institutions or trillion-dollar bailouts.
Chief of Staff: I was not around then. Please help me understand it better.
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Volcker: It was 1980. We were meeting at Camp David. Present were President Carter, myself, the Treasury Secretary, plus others. In some ways, this meeting today reminds me of that meeting then — the same sense of siege, similar philosophical disagreements. But there was one aspect we all agreed upon: The reality of the spreading investor mistrust in U.S. government bonds.
That mistrust was so intense and so widespread, we could not sell long-term government bonds. No one wanted them and the entire market for them was as close to a total shutdown as it’s ever been in the history of our country.
Fed Chairman: But that was because of inflation. Now we have deflation.
Volcker: Relevant in theory, but not in practice. In practice, although the reasons for selling were different, the consequences were the same. Then it was fear of inflation. Now it will be fear of exploding deficits, fear that we will go wild with more bailouts. In both cases, the end result is crashing bond markets.
Chief of Staff: What is the nexus of the crisis?
Volcker: The dealer network for U.S. government securities. The U.S. government is like General Motors. It issues bonds like GM makes cars. And like GM, it rarely sells those bonds directly to the public; it distributes them through a dealer network. The dealers buy the bonds wholesale. They hold them in inventory. They mark them up. And they sell them retail to customers.
Now, imagine what would happen if GM’s dealer network were to shut down! How would GM be able to sell its cars? That’s the same kind of situation the U.S. government was facing for its bonds in those dark days of early 1980 — and the same kind of crisis that seems to be brewing now.
Back in 1980, nearly all the government security dealers were shutting down their government bond operations. They had no other choice. They could not afford to hold bond inventories sinking dramatically in value. By February 1980, they had lost so much money from falling bond prices, they refused to buy them at auction and hold them in inventory.
Salomon and Merrill were the only ones still trading. Salomon would call Merrill to sell what’s considered a small lot of, say, $100 million in 30-year Treasury bonds. At the same time, someone else at Merrill would call Salomon to place a similar trade. It was like two kids on the street corner trying to trade each other the same marbles. There were no buyers. Virtually all the other dealers had packed up and gone home.
Three-month Treasury bills? No problem. Investors trusted us for three months. But 20- or 30-year Treasury bonds? No! The market for Treasury bonds had dried up. And without it, the U.S. government simply could not continue to fund its own operations, couldn’t meet payroll. Hard to believe, but true: We faced a shutdown of the U.S. government.
Our only answer was to kill the source of the mistrust, which, at that time, was inflation. But to do that, we had to jack up interest rates. We had to cut off credit to millions of Americans. And in the process, we knew, or we should have known, we were going to squash the economy.
Carter was up for re-election. So you can imagine his initial resistance to the Draconian steps we were proposing. But he had no choice. He could either (a) risk the possibility of losing the election in November or (b) face the certainty of a government shutdown in March.
Treasury Secretary: Can we bring this back to the present?
Volcker: Absolutely. Let’s bring this back to the present by asking this question: Is this the direction you want to take the country? If anyone in this room is willing to take that risk, say so now or forever hold your peace.
Because that’s the fork in the road we are now approaching — the end of the fast lane we’ve been on. I’m referring to the fast lane of open-ended government bailouts. The fast lane of “consistent messaging” to cover up the true cause — and the true consequences — of these bailouts.
Mr. Secretary, never forget: Millions of investors, mostly overseas, have put their faith in U.S. government securities. They’ve loaned you their money because they trusted you, the U.S. Treasury Department. If you continue to pour their money into these bailouts, what do you think their reaction will be?
What makes you believe that they’ll respond any differently than they did in 1980, when they disappeared from the U.S. government security market or, worse, dumped their bonds in fear? What makes you believe you can stop the cancer of mistrust from spreading to 1500 Pennsylvania Avenue — to the U.S. Treasury Department itself?
Now that day is approaching. Now we must make absolutely sure that U.S. Treasury does not, itself, become the next victim of the greater subprime crisis. Fortunately, it is not too late. We can still save our country’s credit if we act today, right now, while we still have a country, while we still have the resources as a nation to make the needed sacrifices.
This is the last government rescue, and it must be to save the government itself.
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