0:36 Intro. [Recording date: November 21, 2011.] Our topic for today is the financial crisis and your book, 13 Bankers. Let's set the stage: What changed in the last 3 decades or so in the relationship between the American economy and the financial sector? Because the financial sector recently--before the crisis and in the run-up to the crisis--played a very different role in the economy than it had before. What was different? That's exactly the right way to come at this issue. For 150 or so years in the creation of the American republic and the creation of the greatest industrial power the world's ever seen, finance was not particularly a critical sector. We certainly didn't rely on big banks. And after the Great Depression, banking was quite tightly regulated in the United States. I think it played a particularly healthy role in financing entrepreneurs, creating venture capital, sector and so on and so forth. But from the 1970s it really changed dramatically, because the banks became bigger; they were able to take on more risk; and eventually they were able to blow themselves up, at great cost to society. Their profits increased dramatically over that time period--their profits as a share of the economy, their role as an employer increased, although not quite as dramatically. Why did that change? What do you think we understand about that transformation? And certainly, as you point out: Banking was a steady, important part of the American economy before this period. But something changed dramatically in the 1970s, 1980s, 1990s, and 2000s. Why did that happen? I think the best symbol of what changed was in the early 2000s, when profits were 40% of total corporate sector profits. And that was obviously a misstatement, because subsequently they ran up big losses. You don't go back and reduce that profit in an actual account. But the big issue was everyone would take on risks. So, you take a lot of risks now, you show the upside, you pay yourself a lot of money, and then the downside gets shoved onto the taxpayer one way or another. So, it's the ability of the financial sector. You need finance to take risks, to provide equity investments and sometimes provide debt investment to entrepreneurs and that's fine. But the financials went way beyond that in the past couple of decades. They developed an ability to take risks at the macroeconomic scale and risks that really have no counterpart in terms of benefits for the economy. We are not getting better allocation of capital. It looks a lot worse, actually. Right now it looks terrible. Of course, we are trying to come of a pretty deep recession, so it's hard to be sure. But you can't make the case that the allocation of capital improved in the 2000s or 1990s compared to where it was in the 1950s and 1960s. When I look at that I always point out that putting trillions of dollars into housing is probably not the most productive use of scarce capital. As you say, it's hard to say. I try to take a pretty agnostic view. If genuine markets allocate capital one way, I feel that's sort of their business and I'm happy with the market outcome. If it's a matter of government subsidies pushing capital toward housing, which is obviously what happened in part, and then the private sector rides the cycle with massive leverage and risk taking for private benefit, then we have a problem.

4:46 The two views of this expansion of the financial sector: One view is that they do mostly allocate capital wisely and we should trust what they do because they have a profit incentive; the other view over this time period was they don't do anything. They don't make anything. All they do is speculate and push pieces of paper around. And I have to confess that I was always on the side that said they are looking out for their profits; and of course if that's what the market signals them to do, that's going to be okay. What I neglected was the loss side that we insulated the financial sector from, and that is clearly part of the problem. Absolutely. I think of myself really as a follower of George Stigler. Stiglerian, perhaps? Stigler's point was that when you regulate industries, the industry will turn around and capture the regulation; in utility pricing, you get inefficiencies of various kinds, for example. But for banking, which wasn't Stigler's focus because banking wasn't a big issue when he was doing his work, it's much worse. The banks can turn around, capture the regulations, get themselves permission to take on all kinds of crazy risk. Great private benefits. In this case it seems like it was mostly for the management, not even for the shareholders. But the shareholders thought they would, and certainly some of them did if they got out early. There was a lot of volatility for them to take advantage of if they did the timing right. Good point. So, the shareholder calculations always have to take that into account. But if you look at buy and hold shareholders of the past 20 years of the big banks, they've not done particularly well. At a time when people who built up those big banks and ran them as their growing empires did incredibly well on a cash basis. The regulatory capture--interesting example in this particular case that I think has been a little bit misunderstood. Part of it hasn't been detailed very well, and I think you do the best job that I've seen, in 13 Bankers, and we're going to come back to that capture and deregulation that helped banking. But I think the weird part about this is that on paper, it didn't look very much like capture because "all the bankers got permission to do was to be highly leveraged on very safe things." And that seems to be okay. If you said on paper in the abstract: Should banks be allowed to borrow more, to use less capital in areas where they are investing in safe things? Well, that makes sense. That was the basis for Basel I and II, to say, well, if you are investing in triple-A, which is safe, then it's okay. But what was neglected was the ability of the financial sector to create triple-A. At the time, triple-A was scarce. So, they said: Well, we'll fix that. If that's the thing that we are able to run wild on, okay, fine. I view this as a really depressing bit of entrepreneurship on the part of the financial sector; and again, those of us who are market oriented I think defended that wrongly at the time by saying: This is innovation, giving people more access to housing. We didn't realize that the downside risks were being protected for the banks and therefore they were acting very recklessly. I think that it. You just described one of the most sophisticated regulatory capture schemes in the history of human kind. Not saying there was a conspiracy, not saying they set out to do it; but that is the way in which competition pressed them forward, I suppose; and Basel in my view is absolutely part of the problem. Because if you take the position that somebody can tell you what's risk free--and I don't care if it's a regulator or a banker or an academic--I don't believe them. Your point about manufacturing risk free assets is correct at least about the American system. But look at Europe today. It's triple-A, formerly known as triple-A sovereign debt that is at the heart of the problem there. And by the way, a lot of our problems over the last few years may end up in the history books as being the forerunner, the lead up to, the really big crisis, which is the European sovereign debt crisis. Because we've never seen a crisis on this scale for "safe" debt. Not in the modern period. I think your point is the right point: There's no such thing as safe debt. I think everybody who plays in this world understands it. They may forget it from time to time, and we may reduce their incentives to remember it; but everybody understands there's no such thing as a risk free asset. So there was sort of this illusion fostered by political and economic forces that these were safe things. It's not that they were safe things to invest in. That's a mistake and if you turn out to be wrong, you pay a price--you lose your money. The real problem is that they were safe things to invest in with a lot of borrowed money rather than one's own capital. If you risk your own capital and you lose it, you lose; you have a bad quarter or a bad year; maybe you are wiped out. The problem we are dealing with now is that we allowed, we encourage the use of leverage to finance this, which is what is going to create the mother of all storms. Absolutely. And of course it's not just leverage. It's the scale. So we might distinguish between what we could call the John Corzine problem and the Chuck Prince problem. John Corzine--MF Global--that's the view of sovereign debt being safer, and if MF Global failed, $40 billion dollar balance sheet, who cares. I looked quite carefully around the world; you can see barely a ripple from that failure. Chuck Prince famously bet massively on mortgage backed securities and said you've got to keep dancing as long as the music is playing. At the moment he said that, I believe the music had already stopped. He was the head of Citibank; and that was a $2.5 trillion balance sheet that went down; and was saved by the U.S. taxpayer on incredibly ridiculously generous terms. People do make mistakes sometimes and get carried away and there's plenty of hubris in and around Wall Street. That's fine. But why would I want one guy or a small set of guys to control $2.5 trillion dollar balance sheet, and getting bigger--because these guys want to get bigger--to be able to bring down a big chunk of the economy like that and have massive damage?

11:22 We're going to come back to what can be done about that, but before we do that, I want to go back to the history lesson, because again I think people on the right--and this would include myself; I'm not on the right but I'm a free market type so people put me on the right--the right's very skeptical about this idea that deregulation is the source of the problem. And they say: What deregulation are you talking about? The financial sector is one of the most highly regulated industries in the American economy--which is true. But what can you point to, and one of the things people point to is the Gramm-Leach-Bliley Act (GLB)--which is a very hard thing to say--which is the repeal of the Glass Steagall Act. Was that important? I think so, at least a little bit; but I think one of the subtler things that you highlight in the book. Talk about the deregulation and what was important that allowed the Wall Street investment banks to grow so large. It was a process of, you could call it deregulation, or the changing nature of deregulation. The banks are still highly regulated and have been throughout this process, but the restrictions implicit in this regulation on large scale risk taking, those restrictions receded. The end of Glass-Steagall is a symbol, but at that point a lot of the restrictions on big banks have gone away. I would point rather at the sale or the reluctance to have a proper regulatory framework for derivatives, not traded in open markets or over the counter. I think that's important. But even bigger than that was the decision by the Bush Administration, by the Securities and Exchange Commission (SEC) to allow investment banks to massively increase their leverage, based on just their own internal assessments of what kind of risks they would take. You look back and in terms of the big mistakes in financial history, that's got to be in the top 10. And then you've got just the lack of--sometimes deregulation, sometimes change--the whole phenomenon that allowed the security market to expand. And my favorite--this is just a beautiful piece of detective work that you describe in the book--in 1991, which is 17 years before the crisis explodes, Goldman Sachs lobbied to change I think three or four words in a piece of legislation related to the Federal Reserve, which was that the Federal Reserve could open its window only to banks whose assets were based on commercial transactions. Describe what happened there. Goldman Sachs wanted better, more of a backstop, ultimately for itself; and this is exactly the issue of downside risk. If the assets fall in price or any investment. In the modern economy we run a fiat money system; any central bank is a very appealing place of last resort. Goldman makes essential progress then, and later, but still needed to become a bank holding company in September of 2008 in order to really be saved. And that's how they operate today. Full backstop from the Fed. But in the absence of that 1991 wording change, that conversion would not have been sufficient. Is that correct? That conversion to a bank holding company would not have been enough? Yes. At least that's our interpretation--that they were very thoughtful and prepared long ago for this kind of eventuality. These are very smart people. This view that says they were just stupid, that they drank the KoolAid, they believed their models--I'm sure as you pointed out earlier there's a lot of hubris and overconfidence, but smart people tend to be aware that things do fall apart sometimes. My claim is that the incentives to be careful about that are what disappeared. I'm sure you are right. And if you go back to the original debate about the founding of the Federal Reserve, at that time we had relatively late compared to most countries; and we also had a relatively open debate; most countries sort of stumbled into modern central banks. Two views of the downside or the drawbacks of having a central bank: one was Nelson Aldrich, of the establishment, which said this will create moral hazard problems for government and that will lead to inflation. On the other side was the Peugeot Committee and Louis Brandeis, before he became a Supreme Court Justice, who said: Well, there's also moral hazard this will create for the financial sector. Because the Wall Street barons, oligarchs, will be able to draw on this credit when they need it; and that will encourage them to take excessive risks. I have to say, looking back over 100 years, the experience of many countries or the experience of Europe today in the Eurozone, there are many instances like that of Greece who have proved Nelson Aldrich is right; but there are other instances, most spectacularly recently that of Ireland, that prove Louis Brandeis was also right. Describe--talks about Greece and Ireland and how those countries illustrate those two views. It's two types of moral hazard--not being careful, over-borrowing. And the problem is the markets, you could say, encourage you or the don't warn you that you are getting close to over-borrowing. So, Greece ran big budget deficits, didn't do sensible fiscal adjustments, papered over the cracks; also it seems helped by some deals that concealed the true nature of their indebtedness until it was a bit too late. But that's the government over-borrowing, and that's made possible by a financial sector that has incentives for example to hold "risk-free" government debt. Never risk free. There's a second set of problems though--in Ireland, almost entirely about the private sector. The government was running a low deficit, actually surpluses; debt-to-GDP was low, in the 20% range, lower than most other industrialized countries. But three big banks increased their balance sheets, took a lot of risk, combined were two times the size of the Irish economy. They blew themselves up on bad commercial real estate, largely, residential real estate. That caused so much fiscal damage to the Irish government that they were forced to go get a loan from the International Monetary Fund (IMF) and the European Commission. So, for Greece, the government's gone wild; Ireland, the damage is done by bankers gone wild. It's the same difference, and that's the original Aldrich-Brandeis combination of points. When you have a central bank, when you have a backstop, when people think they are going to be bailed out, they are not careful.

18:21 Now in 2008 American policy makers made a series of decisions which I view helped create the current mess we are in now, in the aftermath of that, and certainly raised the chances of future crises. One of those decisions was the guarantee the assets of Bear Stearns to allow their creditors to lose zero, which sent a signal to markets, which was: Keep going, keep dancing. There was a decision not to rescue Lehman Brothers, which has been interpreted I think somewhat incorrectly as the source of the problem. That in turn was followed by a series of relentless rescuing. AIG--every AIG creditor got to keep all their money, including obviously some large politically powerful organizations. And then finally the Toxic Asset Relief Program (TARP), hundreds of billions of dollars into the balance sheets of banks, on the grounds of keeping banks in health to avoid a crisis. The TARP was kind of the punchline of that period. What might have been done differently? What other options should have been on the table? In all those cases, by the way, there was almost no debate, even among so-called experts, at the time; certainly for Bear Stearns people said: We had no choice. I disagree, but that was the common consensus. TARP, there was a debate about exactly what might be done with the money. But if you had been in charge--dream for a minute--what would have been done differently at those checkpoints. Good question. I think the key in all these situations is that you want creditors to face a lot of risk. Maybe not huge losses, certainly not losses that would be catastrophic and have big spillover effects to the rest of the economy. And you would like them to know what their losses are up front so they don't have to worry about the uncertainty. For example, Lehman is still not entirely settled, people are going to get out. It looks like about 20 cents on the dollar. Right, but it takes you three years to get to that--uncertainty. I think as you alluded, some losses for the creditors of Bear Stearns would probably have been a good idea. Not saying that would have nipped this thing in the bud but it would have given people the incentive to slow down. And certainly in the TARP and post-TARP bailouts--of course there are more programs; there's also all the guarantees provided by the Federal Deposit Insurance Corporation (FDIC) and there's all the asset support actions taken by the Federal Reserve one way or another. All the windows they opened. You need to have change of control. You can't keep the same management running the banks when you are saving them. You need to change boards of directors, you need to change executives. When you've decided that it's systemic, of course, you can't change all management in all the banks; but I think that's something of a smokescreen, and really at the biggest banks they should have had a change in management, a change in the boards of directors. Whether you could have had credit take a hit in the late fall 2008, early spring 2009--that is debatable. I think that's the danger going forward, that you find yourself in a situation where well-informed people believe that it's the choice between global calamity or bailout. That reminds me of this moment in the crisis when I think Hank Paulson and maybe Tim Geithner came to George Bush II and said: We have to bail out AIG. And Bush supposedly said: Well, it's regrettable but I accept your point; we have to do it; how did we get to this point? How did we get to a world where that's our choice--global calamity or unsavory bailout--he didn't phrase it that way, he said it a lot better--but that's a very unsavory choice and obviously you want to avoid having to make that choice. And of course faced with that choice, policy makers almost always choose unsavory--bailouts of cronies--which I think is really destroying perceptions, correctly so, of the fairness of the system. Absolutely. The unsavory bailout is one thing; but as you say, it's the cronies, the people who are very highly connected to the President of the New York Fed. Mr. Geithner, people he socialized with, people with whom he was on board; and of course people he knew had spent a long time on the phone with in early 2009. Now, that's a perception problem for sure; but the reality is also pretty bleak in modern American context. And the criticism of banks--you look back historically, look at the various ways of critiques that we've had. Sometimes the people who criticize big banks for their actions at the time are called populists. If you look at the history books, they are the ones who look like the sensible people who are just calling for restraint and responsibility.