by William K. Black, New Economic Perspectives
Whatever else comes out of the release of the audio tapes by Carmen Segarra, they have harmed the reputation of Mike Silva, the long-term senior supervisor at the Federal Reserve Bank of New York (FRBNY). The (lengthy) excerpts below are taken from the This American Life program and are necessary to understand the context.
Mike Silva I have to tell you that night that the reserve fund broke the buck and we got that word…
Jake Bernstein It was a moment when it looked like the financial system was going to come crashing down. Big firms were frantically calling the Fed, terrified that economic
Armageddon had arrived. When this happened, Silva was chief of staff for Tim Geithner who, at the time, was president of the New York Fed.
Mike Silva And when I realized that nobody had any idea how to respond to that, I went into the bathroom and threw up. Because I realized this is it, it’s just this small group of people, and right now at this moment we have no clue. I never want to get close to that moment again.
Jake Bernstein Silva told his staff that this was a very powerful experience that still influenced his thinking. And you could hear that in the recordings after the unusual deal came down late that Friday afternoon involving the overseas bank, Banco Santander.
What upset Mike Silva about it was that it seemed like the entire purpose of the transaction was for Goldman Sachs to help Banco Santander appear healthier than it actually was.
One Fed employee likened it to Goldman getting paid to hold onto a briefcase. And as best as they could tell, Goldman was paid a lot: at least $40 million with the potential to make hundreds of millions in the end. Mike Silva referred to the deal this way.
Mike Silva It’s pretty apparent when you think this thing through that it’s basically window dressing that’s designed to help Banco Santander artificially enhance its capital.
Jake Bernstein To be clear, the deal appeared to be perfectly legal. Silva knew that. But still, he wondered, did they want banks doing these sorts of transactions in the future? If this kind of deal took off and became more popular, could it be a problem?
Mike Silva My own personal thinking right now is that we’re looking at a transaction that’s legal but shady. I want to put a big shot across their bow on that.
Poking at it, maybe we find something even shadier than we already know. So let’s poke at this thing, let’s poke at it with our usual poker faces, you know. I’d like these guys to come away from this meeting confused as to what we think about it. I want to keep then nervous.
[WKB: Then comes the actual meeting with Goldman.]
Jake Bernstein. Silva wasn’t satisfied. Finally, after more than an hour he went for it. It’s the only time in the whole meeting he brings it up. We play it now, not because this is an important piece of financial policy, but to give you a chance to hear what it sounds like – at least on this one day – when the top Fed official onsite at Goldman Sachs questions Goldman Sachs.
Mike Silva Just to button up one point. I know the term sheet called for a notice to your regulator. The original term sheet also called for expression of non-objection, sounds like that dropped out at some point, or…?
[WKB: Then comes Silva’s self-evaluation of his success in “pok[ing] at it.”]
Mike Silva At a minimum, we made them, I guarantee they’ll think twice about the next one, because by putting them through their paces and having that large fed crowd come in. You know we fussed at ‘em pretty good.
Lehman’s Failure and the Fed’s Failures
To understand Silva’s reaction to the massive run on Reserve Primary Fund when it “broke the buck” one must understand aspects of Lehman’s failure slightly over six years ago. The Bush administration, stung by criticism of its bailout of Bear Stearns, decided to let Lehman collapse under the weight of its endemic accounting frauds. The Fed and the financial community anticipated Lehman’s failure. The FRBNY took the lead for the Fed in evaluating the imminence and impact of Lehman’s coming failure. I testified before Congress about the indifference, ineptness, and lack of integrity of the (grossly inadequate) three-person team that the FRBNY sent to monitor Lehman’s collapse. One of the most critical functions of such a team was to learn from Lehman what other entities will experience financial stress when Lehman fails because they are Lehman’s creditors or counterparties. The FRBNY team failed on every dimension, including integrity, but the paramount failure must be attributed to the Fed’s and the FRBNY’s senior leadership.
The result was that the Fed took no action to cause Lehman to convert to a commercial bank so that it could be put in a receivership and avoid an unstructured collapse. The Fed, blinded by ideology and its stunning failure to find the facts about Lehman’s interconnections, was caught like a deer in the headlights of a 24 wheeler truck when Lehman’s bankruptcy immediately caused a catastrophe. The incident led Silva, Geithner’s chief of staff, to understand for the first time (1) that his ideology and that of his bosses was a false religion, (2) that their decision to allow Lehman to fail was disastrous, (3) that the global financial system was at risk, (4) that the Fed had no clue what other disasters Lehman’s failure might trigger, and (5) that none of his bosses “had any idea how to respond….”
These profound realizations understandably led Silva to go “into the bathroom and thr[o]w up.” The lesson he says he drew from the experience is sensible: “we ha[d] no clue. I never want to get close to that moment again.”
Reserve Primary Fund: The World’s Largest and Fastest Run
I’ll begin with a clarification. When the transcript shows that Silva refers to “that night that the reserve fund broke the buck” he was referring to the Nation’s first money market mutual fund, Reserve Primary Fund. The fund was also the Nation’s fastest money market mutual fund. It grew so rapidly by offering slightly greater yield – and by taking considerably greater risk by investing primarily in commercial paper (short-term debt issued by large corporations) instead of almost exclusively U.S. government securities. Money market mutual funds are supposed to be ultra-safe savings funds that take minimal risk. To “break the buck” is to suffer losses such that the money market mutual fund will be unable to repay the investor’s principal in full. Because investors chose such funds due to their exceptionally low risk, they react to any potential risk of loss by withdrawing their funds from the money market mutual fund. This can produce a massive run on the fund because their very large investors are typically financially sophisticated and invest tens or even hundreds of millions of dollars in money market mutual funds.
“On September 15 , when Lehman declared bankruptcy, the Primary Fund’s Lehman holdings amounted to 1.2% of the fund’s total assets of $62.4 billion. That morning, the fund was flooded with redemption requests totaling $10.8 billion. State Street, the fund’s custodian bank, initially helped the fund meet those requests, largely through an existing overdraft facility, but stopped doing so at 10:10 A.M. With no means to borrow, Primary Fund representatives reportedly described State Street’s action as “the kiss of death” for the Primary Fund. Despite public assurances from the fund’s investment advisors, Bruce Bent Sr. and Bruce Bent II, that the fund was committed to maintaining a $1.00 net asset value, investors requested an additional $29 billion later on Monday and Tuesday, September 16” (FCIC 2011: 356-357 ).
By way of perspective, a $6 billion run, over the course of weeks, led to the failure of Continental Illinois, one of America’s largest banks. Within roughly two hours of the announcement of Lehman’s bankruptcy the Primary Fund suffered a run almost twice that size and its line of credit had already been yanked. The Fund’s managers promptly made dutiful “assurances” that they were “committed” to not breaking the buck (“maintaining a $1.00 net asset value”) – and their corporate customers responded to those assurances by pulling out another $29 billion within the next 24 hours. Withdrawals – within two days – represented roughly half of the Primary Fund’s total assets. In economic terms, the Primary Fund was a zombie within minutes of the announcement of Lehman’s bankruptcy. The Primary Fund’s managers and the private sector as a whole had no means of stopping the run and saving the Primary Fund. Indeed, the private sector was actively destroying the Primary Fund even though that act of destruction endangered the global economy. “Private market discipline” frequently fails to operate (indeed, large creditors routinely fund the rapid growth of accounting control frauds), but even when it functions its results can be suicidal for the system.
Note that the speed of these actions demonstrates that market experts knew that the Primary Fund was exposed to lethal risks because of its purchase of Lehman’s commercial paper. The market participants knew that a seemingly small investment (1.2% of the Primary Fund’s portfolio) could be fatal to its survival.
The Fed knew months earlier that (1) Lehman was doomed and would prove massively insolvent due to its many forms of accounting control fraud, (2) many Lehman creditors assumed that the U.S. government would bail them out, (3) the creditors’ assumption that they would be bailed out was wrong, and (4) this exposed Lehman’s creditors to enormous losses. These four factors made it essential that the Fed determine, quantify, understand, and be prepared to respond to the consequences of those exposures. The Fed had unique access to information on Lehman’s creditors through its on-site team at Lehman. Other financial participants, despite their lack of access to Lehman’s records, knew that the Primary Fund was critically exposed to Lehman. Silva is saying that the Fed had “no clue” about the Primary Fund’s exposure to losses on Lehman’s commercial paper and “no clue” about how the Fed should respond to the resultant run on the fund.
The Run on Money Market Mutual Funds Spreads
Scores of large banking sponsors of money market mutual funds stepped up to save their funds, but the overall result was that the run on the Primary Fund spread to large numbers of money market mutual funds and reached epic proportions.
“After the Primary Fund broke the buck, the run took an ominous turn: it even slammed money market funds with no direct Lehman exposure. This lack of exposure was generally known, since the SEC requires these funds to report details on their investments at least quarterly. Investors pulled out simply because they feared that their fellow investors would run first. ‘It was overwhelmingly clear that we were staring into the abyss—that there wasn’t a bottom to this—as the outflows picked up steam on Wednesday and Thursday,’ Fed economist Patrick McCabe told the FCIC.
‘The overwhelming sense was that this was a catastrophe that we were watching unfold.’
‘We were really cognizant of the fact that there weren’t backstops in the system that were resilient at that time,’ the Fed’s Michael Palumbo said. ‘Liquidity crises, by their nature, invoke rapid, emergent episodes—that’s what they are. By their nature, they spread very quickly.’
An early and significant casualty was Putnam Investments’ $12 billion Prime Money Market Fund, which was hit on Wednesday with a wave of redemption requests. The fund, unable to liquidate assets quickly enough, halted redemptions. One week later, it was sold to Federated Investors.
Within a week, investors in prime money market funds—funds that invested in highly rated securities—withdrew $349 billion; within three weeks, they withdrew another $85 billion.
Money market mutual funds needing cash to honor redemptions sold their now illiquid investments. Unfortunately, there was little market to speak of” (FCIC 2011: 357).
Which Sparked a Run on Commercial Paper
Money market mutual funds are massive and the world’s largest run would have been sufficiently terrorizing to send many a supervisor rushing to the bathroom to vomit. The run sparked by Lehman’s collapse spread within days to the commercial paper markets.
“And holding unsecured commercial paper from any large financial institution was now simply out of the question: fund managers wanted no part of the next Lehman. An FCIC survey of the largest money market funds found that many were unwilling to purchase commercial paper from financial firms during the week after Lehman. Of the respondents, the five with the most drastic reduction in financial commercial paper cut their holdings by half, from $58 billion to $29 billion. This led to unprecedented increases in the rates on commercial paper, creating problems for borrowers, particularly for financial companies, such as GE Capital, CIT, and American Express, as well as for nonfinancial corporations that used commercial paper to pay their immediate expenses such as payroll and inventories. The cost of commercial paper borrowing spiked in mid-September, dramatically surpassing the previous highs in 2007…”
“You had a broad-based run on commercial paper markets,” Geithner told the FCIC. “And so you faced the prospect of some of the largest companies in the world and the United States losing the capacity to fund and access those commercial paper markets.” Three decades of easy borrowing for those with top-rated credit in a very liquid market had disappeared almost overnight. The panic threatened to disrupt the payments system through which financial institutions transfer trillions of dollars….” (FCIC 2011: 358).
In the end, these runs were only halted by the federal government providing a series of backstops (FCIC 2011: 359-360).
Then Morgan Stanley and Goldman Sachs Suffered Runs
The runs now moved to the remaining large investment banks. Merrill Lynch would have collapsed but for an acquisition. Morgan Stanley became the next target, followed by Goldman Sachs. Both were saved by federal assistance programs (FCIC 2011: 360-363).
Silva’s Not Very Insightful Insights from this aspect of the Financial Crisis
There are a wide range of insights that Silva could have drawn from these episodes. He told his staff that he intended to learn the lessons essential to avoiding ever being placed in that position of helplessness again, and I assume that he was sincere in that intent. The secret audiotapes, however, demonstrate that he has not succeeded in learning the essential lessons. The relevant portions are the passages in which Silva reacts to Goldman’s aiding and abetting Banco Santander’s effort to scam its capital requirement.
My testimony on the causes of Lehman’s failure before Congress can be summarized briefly. Lehman was an accounting control fraud that maximized the senior officers’ compensation through a series of accounting frauds, particularly through the fraudulent origination and sale of liar’s loans. Over time, Lehman’s liar’s loans were increasingly subprime liar’s loans – the most toxic of the toxic mortgages. Lehman also engaged in accounting fraud to understate its liabilities and to avoid recognizing large losses on its bad commercial real estate investments.
The Valukas report made infamous the “REPO 105” scam that it used to deceive investors into believing that its liabilities were smaller than the reality. A REPO (repurchase obligation) transaction is structured as if it were a sale and repurchase agreement, but is in reality simply a means of borrowing. Lehman’s REPO 105 deals did not actually reduce Lehman’s liabilities and were not undertaken for any legitimate business purpose. The deals were done solely to understate Lehman’s actual liabilities by taking them off balance sheet just before the end of the quarter.
Understating a firm’s liabilities is highly deceptive to shareholders and creditors and dangerous to the system because it leads to a reduced capital requirement. The understatement of the firm’s liabilities poses the greatest danger when it has inadequate capital – which was the case at Lehman, which was insolvent on any real economic basis for at least two years prior to its bankruptcy.
Lehman Reprised Many of Enron’s Primary Scams
What tends to be forgotten about Enron’s frauds is that many of the world’s largest banks aided and abetted Enron’s frauds, that they did so by helping it scam the rules on Special Purpose Vehicles (rebranded in the current crisis as Special Investment Vehicles), and that one of Enron’s principal goals in using the banks to fund the SPVs was to move liabilities off book in order to deceive investors and creditors. This mechanism was substantively very similar to the role Goldman Sachs was playing to aid and abet Banco Santander’s efforts to scam its capital requirements by understating liabilities through transactions that had no substantive business purpose.
The Lesson Silva Should Have Taken from Lehman’s and Enron’s Frauds and Failures
The overriding lesson that Silva should have taken from Lehman’s and Enron’s frauds and failures applicable to Goldman helping Banco Satander to scam its capital requirement by using accounting games to take liabilities off its balance sheet – was to stop it. Let’s review the bidding, the Fed had witnessed two huge scandals that involved similar scams – one of which (Enron) defined a scandal-prone era while the other (Lehman) would have destroyed the global financial system (including Goldman) but for a massive government bailout of the banks.
The Fed’s response to each of these accounting scams was incompetent and despicable. The Spillenkothen memorandum to FCIC reveals:
- The Fed’s leadership (Greenspan and clones) wanted to take no action again the elite banks that knowingly aided and abetted Enron’s (and Fastow’s) frauds. The leadership was distressed that the SEC decided to give the banks a slap on the wrist, mandating (politically) a similar response by the Fed.
- When Spillenkothen (the long-time head of Fed supervision) insisted on asking to brief the Fed’s leadership about the banks’ criminal actions in aiding and abetting Enron’s frauds the leadership responded to the facts by becoming enraged – at Spillenkothen for having dared to criticize the banks and bankers given the Department of Justice’s failure to indict the banks. Think about that standard for a moment – if DOJ doesn’t prosecute the regulators have no right to criticize banks and bankers. That’s a prescription for disaster.
The other part of the tale was foretold by my spouse’s brilliant law school classmate, BU Law Professor Susan Koniak and three superb colleagues. The four authors made the link between Enron’s scam, Lehman’s REPO 105 scam, and Goldman’s similar scam with Greece explicit in an April 4, 2010 op ed entitled “How Washington Abetted the Bank Job.” in the New York Times that Silva could not have failed to read. The four authors explained in detail to the banking regulators, in writing, that the proposed reforms they were proposing in response to Enron’s scams were pathetically weak and would fail. The banking regulators responded by making the proposal far weaker so that it was a farce.
The Fed team sent into Lehman learned quickly about its REPO 105 scam – and deliberately did not inform the Securities and Exchange Commission (SEC). The FRBNY thought that disclosure of Lehman’s scam could speed its inevitable collapse. The Fed, and the FRBNY under Timothy Geithner, in this era were part of what Tom Frank aptly labeled “The Wrecking Crew.” We knew that President Obama would be a disaster on big banks when he promoted and reappointed the twin architects of the financial wrecking crew – Ben Bernanke and Geithner. Note that Obama, a self-styled “New Democrat” of the Bob Rubin wing of the party was happy to reappoint a partisan Republican like Bernanke to the most powerful finance position in the world.
Banco Santander and the Importance of Real Capital and Avoiding Scams
Banco Santander is Spain’s largest bank and it is well into the “too big to fail” category. Spain is suffering a Second Great Depression due to the troika’s economic malpractice in inflicting austerity. Spain suffered the second worst real estate bubble (measured as a percentage of GDP) of any advanced economy during the crisis as the essentially unregulated banks engaged in an orgy of lending that would never be repaid. Spain is so opaque that it is difficult to determine what portion of the lending was fraudulent.
What we all should be able to agree on is that Banco Santander desperately needs more capital and that among the last things in the world any real banking regulator would do is permit it to work a Lehman/Enron/Greek type accounting scam designed to take liabilities off the books in order to reduce Santander’s capital requirements.
We should all also be able to agree that there is a vital need for bank regulators to say no to Goldman – the author of so many similar scams (think Greece) and a bank that would have been destroyed by Lehman’s similar scam but for the U.S. Treasury and the Fed bailing them out. One of the primary missions any real bank regulator with jurisdiction over Goldman would prioritize is producing a sea change in Goldman’s pervasively unethical approach to banking (and yes, that would include its reprehensible approach to conflicts of interest – the specific supervisory effort that got the Fed whistleblower Segarra fired by Silva).
Finally, we should all be able to agree that the fact that a deal might be “perfectly legal” does not mean that a banking regulator should allow it. The following passage is the most demented portion of the This American Life program.
A “Perfectly Legal” Scam is Perfectly Unacceptable to Real Bank Supervisors
Mike Silva It’s pretty apparent when you think this thing through that it’s basically window dressing that’s designed to help Banco Santander artificially enhance its capital.
Jake Bernstein To be clear, the deal appeared to be perfectly legal.
So, it’s “apparent” that the deal was a scam. Silva knew it was a scam. His team knew it was a scam. As a former senior banking lawyer/regulator who worked with real supervisors let me assure the reader that there can be real supervisors and that no change in law was required for Silva to block a “perfectly legal” scam designed to “artificially enhance” a bank’s reported “capital.” Such a deal is “unsafe and unsound” and it abets an “unsafe and unsound” act. We would have ordered Goldman to terminate the scam and if its senior managers refused to comply we would have brought a “cease and desist” order against Goldman and a “removal and prohibition” order against the senior managers. We would have won both actions. The federal banking regulators have explicit statutory power to act against “unsafe and unsound” banking practices. (As a footnote, it is impossible for us to know whether the Goldman/Santander scam was “perfectly legal.” The Fed did not investigate, much less investigate vigorously and competently. Neither the (non) regulators nor the media has access to the facts necessary to determine the legality of the deal.)
The problem at the FRBNY is a lack of will and an institutional conflict of interest that I will explain in a future article. The problem is not a lack of law. The primary forms of “capture” at the (main) Fed, which is also prevalent in the regional FRBs, are ideological and class. Silva represents a common, sad case. He plainly was terrified of the results of the Fed’s failures – failures that were made inevitable by Greenspan, Bernanke, and Geithner. He hoped to learn the lessons of Lehman’s frauds and scams, but he is operating in an environment where one is not permitted to learn the real lessons and the type of vigorous people who would learn those lessons and act on them are actively blocked from becoming Fed staff. Some mistakes are inevitable in weeding out the vigorous before they are hired, but the Segarra case shows that the Fed understands that the key to dealing with such mistakes is the old Japanese adage: “the nail that sticks up gets hammered down.” The Fed seeks to fire anyone with a backbone during her probationary period.