By Nathan Stovall for SNL Financial
William Isaac served as the chairman of the FDIC from 1978 to 1985, overseeing the resolution of numerous failed banks, including the winding down of large institutions such as Continental Illinois, the nation’s seventh-largest bank prior to its failure in 1984. Isaac is now the chairman of LECG Global Financial Services and Fifth Third Bancorp.
In his recent book “Senseless Panic: How Washington Failed America,” Isaac provided an inside account of the banking and savings and loan crises of the 1980s and compared that period to the financial crisis of 2008. The book also offers criticisms of past policy decisions and of regulators’ reactions to the most recent crisis and recommends reforms to prevent future crises.
SNL Financial spoke with Isaac the morning before he delivered a speech on his book at the Rodman & Renshaw Global & Investment Conference. In part 1 of the interview, Isaac highlights what he believes were the worst policy decisions made before the crisis, what regulators should have done to prevent the crisis and why he believes Lehman Brothers Holdings Inc. should have been saved.
What follows is an edited transcript of the conversation.
You outline a number of policy mishaps in your book that you believe contributed to the crisis and the panic of 2008. If you could point at the biggest blunder, it seems like you would single out the SEC for changing pro-cyclical reserving, or possibly FASB for implementing mark-to-market accounting.
Competing heavily with Basel II.
The policies seem hard to defend in retrospect.
They were very hard to defend prospectively. I’ve been arguing against Basel II forever and testified in front of the Senate Banking Committee three times.
Mark-to-market accounting seems very unpopular and does not have broad support. FASB argues that it improves transparency but it clearly will have a fundamental impact on banks’ business, and that doesn’t seem to bother them.
It’s bizarre. I don’t know how to explain FASB. And by the way, it was three members of the five-member board that voted for the mark-to-market proposal, not all five.
One of whom has since planned to retire. Robert Herz, the outgoing chairman, was the deciding vote.
Now they’re adding two more board members, so hopefully they’ll get a little more adult supervision there. They are alone. Other than short sellers and others that can benefit from a lot of market volatility and turmoil, I don’t know of anybody who thinks that mark to market is a good idea. The IASB is miles away from where FASB is.
The IASB updated its model to incorporate some similar provisions. But, as the two groups have worked to converge, FASB seems to have diverged significantly with its recent proposal on fair value.
I don’t see how we can converge with FASB taking this extreme position. In all honesty, I was reluctant about convergence because I thought FASB was tough enough to deal with, and how would you deal with a body that is off in a foreign land? They’re going to be less accountable than even FASB is. But, FASB sure has changed my mind on that. The IASB is under much better supervision. It recommends accounting provisions, but the European Commission can veto it. Nominally, the SEC is supposed to be overseeing FASB, but they don’t oversee them any better than they oversaw Madoff.
You talk about what other regulators could have done to prevent the crisis in your book. You mention that in 1982 when Penn Square Bank failed, you recognized there was contagion risk with Continental Illinois and began to plan for a possible Continental Illinois failure two years before it happened. You argue in your book that there was a lack of planning in the recent downturn. Many people have argued that this cycle happened so much faster, though. Do you agree with that? What could have regulators done, particularly since so much of U.S. banking assets were concentrated among the top 10 banks?
There’s a lot more concentration, which makes it a more dangerous time, which makes it all the more important that you contain problems. People also argue that we are much more interconnected today. I think financial institutions were very interconnected in the ’80s, but if they are even more interconnected, that’s just an even stronger argument for why you can’t let things get out of hand. You really have to stop it in its tracks.
So the government should have stepped in not at September 2008 but perhaps in January 2008?
I’ll admit, in 2007, I thought this crisis was manageable, and the subprime problem was not big enough to cause a lot of problems. I’m just amazed that they let it get so out of control. This crisis wasn’t that big of a deal if they had dealt with it.
So did it happen fast? That’s the nature of the beast. It’s probably going to happen fast, or it would not be a crisis. And it’s probably going to be unexpected, otherwise it wouldn’t be a crisis. By definition, these things are going to happen fast. Walter Wriston, the former head of Citigroup Inc., said that trouble always enters the window you’re not watching.
There was at least one area that regulators were watching that brought a lot of trouble. Regulators issued guidance on construction and CRE lending concentrations in 2006, and yet almost every bank that has failed has a lot of real estate.
A lot of real estate. In 1946, 65% of commercial banks’ deposits were in checking accounts, and they had real estate loans something on that same magnitude. A year or so ago, banks had 5% of so of their deposits in checking accounts, so their funding structure was more expensive. And they had something on average of 55% of their assets in real estate. While we weren’t watching, the banking industry all of the sudden became the S&L industry, which caused the same problem in the 1980s. Why wasn’t somebody watching that? I’ll tell you that I wasn’t, but it wasn’t my job to.
When all interests are aligned, you’re likely to have problems. The interest that was aligned in this case seemed to be home ownership almost becoming more of a right than a dream. Former U.S. Treasury Department Secretary Henry Paulson talked about this during his keynote address at the Rodman conference. He called it a fatally flawed housing policy.
There are a lot of things I disagree with him on, but I don’t argue with that one.
You do seem to disagree with him on Lehman. You said in your book that the government “condemned” Lehman to bankruptcy. Paulson has consistently said that he lacked to power to save Lehman and that Bear Stearns Cos. LLC was a different situation.
His story at the time, as reported in the press, was, “I was not going to go down in history as bailing out another investment bank. I would have been tarred and feathered.” I talked to policy leaders after Bear and before Lehman and there was a real concern — they were very sensitive, and I believe they reacted to that.
I think it was definitely political.
It doesn’t warrant saying that you couldn’t have done the same thing again. Let’s take the original Bear deal. They loaned JPMorgan Chase & Co. $30 billion on a nonrecourse basis. JPMorgan didn’t have any liability, and JPMorgan, in turn, loaned it to Bear Stearns. There’s no reason in the world why they couldn’t have done that with Lehman.
It’s my understanding that the Federal Reserve is allowed to take action in an emergency situation that they believe could threaten the stability of the financial system. I believe that many of the Fed’s liquidity facilities like TALF were created under that power. So what would be the difference with Lehman?
But, let’s stop there. What major bank would not have been willing if they were asked to serve a pass-through for funds to Lehman?
That’s a good point.
The next argument they use is that Lehman didn’t have good collateral.
Paulson actually addressed this at the Rodman conference. He said that American International Group Inc.‘s problems were different because the company’s subsidiaries were profitable, which is true. He also said that lending into a bank run wouldn’t solve anything.
It wouldn’t stop the run? That’s what we did with Continental Illinois. We stopped the run, and it was a very serious bank run. Twenty-five percent of the bank’s funding ran out in a week or two. And our projections were that it would go as high as 50% within a month.
That’s substantially higher than the run on Washington Mutual Inc.. It lost something on the order of $16 billion in 12 days, which is a little less than 10% of its deposit base. Continental was a full-on bank run.
Our projections showed that, if we didn’t do something quickly, the bank would be gone. We loaned into that run, and we stopped it dead in its tracks. You’ve got people making decisions that have never been through it. Why didn’t they turn to people who had actually been through it? They didn’t ask me anything. They didn’t ask [former FDIC and Resolution Trust Corp. Chairman Bill] Seidman about anything. I don’t think they talked to Paul Volcker very much. I looked at Tim Geithner’s phone logs, and I think he talked to Volcker three or four times during that period, and that was after Lehman.
This stuff happens fast. Continental happened really fast, but we were expecting it. When it happened, we had to move. We worked all night with banks to stop it. We had warning signs in 2007; we should have begun planning then.
But even when the run on IndyMac Bancorp Inc. happened in late June 2008, if they had not caught any warning signals before, they should have by then. And they had a lot of warning signs in late 2007. I know that the FDIC saw IndyMac and said it hoped it was the end, but knew to be afraid of it. They were concerned at that time about WaMu, about National City Corp. I know they were because they told me. They weren’t concerned about Bear Stearns or Lehman because that wasn’t their job, but the Treasury, the SEC should have been.
And after IndyMac failed, the FDIC probably should have been concerned with every option ARM lender in America. It’s proven to be a failed product, and every one of those guys has gone out of business. Downey Financial Corp., FirstFed Financial Corp., BankUnited Financial Corp., etc. — they all failed.
I would say to those who said we didn’t have time to do anything, we did have time. We should have been planning. You can hope for the best but plan for the worst, and certainly, in 2008, they should have been expecting the possibility of Bear Stearns and Lehman. Not necessarily thinking that they will fail, but realizing that it could happen and then planning how you’ll deal with it. For instance, back in 1984, I asked the deputy head of liquidations to draw up a war plan for how we’ll deal with 200 community bank failures in a single year, plus three or four regionals and a money center bank. He thought I was nuts and said he didn’t have time to play war games because he was so busy already fighting fires. I didn’t think it was a hypothetical exercise, and we needed to be ready for it. I didn’t know it was going to be happen, and I hoped it wouldn’t happen, but you need to be ready for it.