0:33 Intro. [Recording date: December 2, 2013.] Russ: You've been an outspoken critic of the way policymakers have dealt with the so-called 'too-big-to-fail' problem. I want to start with too big to fail. What is the problem and which banks dos it apply to today? Guest: Well, the problem is that we have banks that are of the size and scale in which senior management of those banks despite their risk management models and highly mathematized ways to try to track things, have in my opinion lost track of the basic principle of banking, which is: know your customer and know your risk. So, we also have institutions that have learned by practice that if they lose track of their risk and track of their customers and make significant errors, they expect to be bailed out by the U.S. taxpayer. These are called 'too big to fails'. Legislation was passed meant to deal with it. It was written by Senator Dodd, who is no longer in the Senate, and Congressman Frank, who is no longer in the Congress. But in the very preamble to that legislation it said that this is to deal with the issue of too big to fail, put it to an end. I don't believe it has. I believe we have created a bureaucratic structure that will continue this process and problem; and the real objective that we have at the Dallas Fed of proposing an alternative, which I'm happy to discuss with you, is to eliminate the risk that the taxpayer will be called upon once again should one of these large institutions get into trouble to bear them out; and also to eliminate the risk that monetary policy becomes a handmaiden of the big, rich institutions rather than of the rest of the country. Russ: Well, I want to get in to your solution, but before we do, I want to have you give us an overview of the industry which you've done in some of your recent speeches. And we'll put up a link to those speeches; they are educational and entertaining. Give us an overview of the banking system and what a small portion of that system we're talking about in terms of number of banks, but what's such a large portion in terms of assets. Guest: We have some 6000 banks in the United States, yet we have concentrated in the hands of literally one handful of institutions of the same amount of assets that you have in the other nearly 6000 community and regional banks. So we have a very highly concentrated sector. And basically what I have been advocating, what we at the Dallas Fed have been advocating, is that rather than be preoccupied with institutions that have been considered too big to fail, because, should they fail--should they get themselves into trouble--it would put the economy at risk because of the high concentration in very few hands; that instead, we structure the law so that we have institutions that are too small to save. That doesn't mean we would not be internationally competitive. There's great specialization that can occur and perform different functions. The markets as you know have been fully developed in terms of the non-depository markets, meaning the bond markets, the stock markets. Large institutions have a great way of financing using markets and not just their bank creditors. But the point is that we have an unlevel playing field. And if you are a small or medium sized bank and get into trouble, you are closed on Friday and opened on Monday. That's the standard FDIC (Federal Deposit Insurance Corporation) rule. Some of them take a little bit longer. But these large institutions, as we learned the last time around, during the panic, should they get themselves into trouble, they are perpetuated. I just don't think that is democratic or fair or proper; nor is it economically sound. Russ: Well, some people would say--I think they are wrong, as a preamble--well, they are not perpetuated. Bear Stearns is gone; Lehman Brothers went through bankruptcy. We can handle it. They didn't get rewarded; their equity holders were wiped out; their management lost a lot of money. What's your position on that? Guest: Well, they were swallowed by somebody else. So you end up with a bigger bank. Like J. P. Morgan or a bigger bank, XYZ Bank. And again I want to make clear that I don't think the management of these companies--I just mentioned one; I think Jamie Dimon is a first-rate individual; he's a personal friend; I hold him in high regard in terms of his personal integrity. It's not a matter of evil individuals. It's just the way these institutions are called upon to rescue somebody else. And in the end receive subsidies in terms of a lower cost of money because of their size and because of their dimensions. And also from the standpoint of an implicit bought[?] that should they get into trouble they will be bailed out. So my biggest concern is these complex financial bank holding companies should all, on the depository side, in the banking side, what we consider commercial banking, should be treated the same way as smaller and regional banks. So this is a subject that we have been discussing at great length. Incidentally, it's a subject that joins both the Left and the Right. It is something that I find is of great interest to, say, Tea Party Republicans, just as it is to the new Senator from Massachusetts--who is by no means a Tea Party advocate. So, it's one issue that unites people from a bipartisan standpoint. I think it's something where the Congress can actually do something about this. And that's the proposal that we've made.

7:11 Russ: Now, how much of a role do you think the expectation of a bailout played in the leverage that we saw in the run-up to the Crisis in large financial institutions? Did we see that kind of leverage in smaller institutions that were small enough to fail? Guest: Well, no, because if a small institution gets into trouble, no one is going to bail them out. And we did have banks fail. And there's also a difference in ownership structure. In many of the smaller institutions shareholders themselves are a smaller group, have more direct knowledge of what's happening with the risks that the institution is taking. But in these very large institutions of course they are widely disaggregated in terms of their ownership. But the point is simply this: too-big-to-fail banks don't face a whole lot of external discipline from their unsecured creditors. And an important facet of too big to fail is that funding sources for these megabanks extend far beyond insured deposits. You could see during the period of prices, the CDS (Credit Default Swap) spreads--these are the spreads in terms of the measurement of risk and insurance on these institutions were widening beginning very dramatically very early on, in fact late 2007. So you would expect that some market discipline was being applied. But in the end these institutions were bailed out. Now the law claims that that will not happen again. But experience points us in a different direction. And all we want to make sure of here at the Dallas Fed is that indeed it is clear that the only taxpayer exposure would be through the commercial banking depository institution and the other aspects of a complex bank holding company would be totally at risk. And we believe that if that is made clear and simple that then the market will sort who actually is good, their brokered dealer operation or their insurance subsidy or their other subsidy areas other than the commercial bank. Russ: The CDS you referred to are credit default swaps, which were a measure of how likely it was that a bank would fail. And if I remember correctly when Bear Stearns failed, Lehman Brothers' credit default swaps--that is the expectation that Lehman would fail--rose quickly. But then once at Bear Stearns it turned out that their creditors would get all their money back, 100 cents on the dollar because J.P. Morgan Chase was taking them, they got quiet again. And Lehman Brothers was borrowing money at the same rate as--it would seem--firms that were much less risky. In particular the question I want to get your opinion on--and then we'll move to your solution: The bailouts of 2008--and I'm talking now about Bear Stearns, AIG, Fannie and Freddie--these were large financial institutions that had borrowed enormous sums of money, and the lenders got all their money back, 100 cents on the dollar. The only exception was Lehman, which was quickly decided to be a 'mistake,' to have that happen. Lehman had to go through bankruptcy proceedings. But the question is: Why do you think the government and policy makers were so unwilling to let creditors take any kind of so-called 'haircut'? That they would have to bear some of the price for having funded and financed such bad investments. Guest: That's the $64 trillion dollar question, just to modernize the '$64 thousand dollar question'. Again, very--and bear in mind I'm a tax [?] and look at it from a mainstream perspective--but very New-York-centric; a deep belief that these institutions, especially the big ones in New York, if they were to get into trouble, if they were to fail, then they would bring down the rest of the system. And as you just noted those different names, of course you realize: those institutions that you just cited were not regulated by the Federal Reserve. They were brought into the Federal Reserve System when they were acquired by the kind of institutions that we do regulate. So they went from being subject to what I would hope would have been significant oversight. It appears that they were not. Secondly, market discipline, into a system in which you had a lender of last resort, which is the Federal Reserve. That provides a different level of comfort. So, I think it's important to know that first, we weren't regulating those institutions. They were poorly regulated; they were poorly overseen. Secondly, they were subject to market discipline, and then they were merged into institutions that are overseen by the Fed, and with the Federal Reserve, a central bank, during the time of a panic, as all central bankers have done going all the way back to the early 19th century, are the lenders of last resort. It changes the discipline. And yet the moderate sized institutions, the community banking institutions of which there are nearly 6000 if you add those two groups together, don't have that kind of protection. So, it's an unlevel playing field and it's unfair. Russ: Well, I'm not so interested in the levelness of the playing field. I mean, a level playing field is a good thing in general, but I certainly wouldn't want the smaller banks to get the benefit of the subsidies. That would be the wrong way to make it level. I think the bigger problem is that-- Guest: They are not only not getting the benefit of the subsidies; they are put at a competitive disadvantage. Russ: True. But to me the more disturbing issue is--besides the fact that the taxpayers ended up being on the short end of billions of dollars, equally disturbing to me is that we incentivized scarce capital to be used for stuff that wasn't so productive. Guest: That's a good point. Russ: It drives me nuts when people say, 'Oh, we have to have a competitive banking system.' How about an effective banking system? Guest: You sound like you've been reading my speeches. Russ: Yeah, well I have. Europe is going to take this sector away from us; and my answer is: Let them. Why does American prosperity depend on that? Guest: Let's remember also, Russ: Remember we went through this period where we were all worried that the French would have the biggest banks in the world? This was many, many years ago. It didn't work. Then it was Japan would have the biggest banks in the world. That didn't work. Then I would hear arguments against my position or our position at the Dallas Fed saying, 'But then the Chinese will pick up everything.' Well, let their taxpayer bear the risk. Let other people bear the risk. And by the way, if they do and it's bad business practice, they will pay the price ultimately. I don't want the American taxpayer to pay that price.

14:23 Russ: So, let's turn to your solution. There are a lot of solutions out there. After you talk about yours, I'm going to ask you to comment on some of the others that have been put forward. This would be a way to reduce the probability of the kind of bailouts that were "necessary." I'm not even sure they were necessary; but certainly policymakers felt they were necessary; and certainly many economists have justified them, arguing that a catastrophe was prevented. I'm agnostic on that; I'm a little bit skeptical. But put that to the side. What do you see--you have a three-part proposal to try to reduce the odds of having to do this again. Lay it out. How would it work? Guest: Consider, first of all, while we are talking about it, we are talking about very complex financial holding companies. So you have a bank holding company that has a commercial bank and then the non-bank subsidiaries of that bank holding company, say, an investment bank--this is really old[?] terminology--you have security subsidiaries, you have insurance subsidiaries, you have real estate subsidiaries and so on. Under our proposal, only the commercial bank would have access to deposit insurance provided by the FDIC. And only would have access to discount window loans provided by the Federal Reserve. These two features of that safety net would explicitly, by statute as we would propose, become unavailable to any of the shadow banking affiliates--that is the special investment vehicles of the commercial bank, or any obligations of the parent holding company that has these complex other subsidiaries that I mentioned earlier. So, that's the first aspect of our proposal: To make it simple, the only exposure that you would have would be to the deposit-taking institution under a complex bank holding company. And then to reinforce the statute that we propose and the credibility of the proposal, with regard to the other aspects of those large complex holding companies, [?] holding companies, every customer, every creditor, every counterparty of every one of those other bank affiliates and of the senior bank holding company would be required to agree to and sign a new covenant. It's a simple disclosure statement that acknowledges their unprotected status. And we even draft one up. Russ: Fits on a postcard, right? Guest: Yep. And I'll read it to you. It's very simple. Russ: Please do. Guest: It's in my memory. 'Warning: Conducting business with this affiliate of the XYZ Bank Holding Co. carries no Federal Deposit Insurance or other federal government protection or guarantees. I, the counterparty, fully understand that in conducting business with XYZ Banking Affiliate, I have no Federal Deposit Insurance or other federal government protection or guarantees and that my investment is totally at risk.' That's it. Now, I know Congress can't write things that simply. They have to make them horribly complicated. Russ: It's too short. It's too short. Guest: So, by the way: I'm not proposing reinstalling Glass-Steagall. Russ: That was my next question. Guest: What I'm saying is: Let these people operate, and those that--I think if you did this, the market discipline would come to be applied to those other subsidiaries, in a way that would allow some people to continue to practice, because they are good at doing it; and others would sort of fall by the wayside. But I do think this two-part step--it's really a two-part step that I've recommended, a two-part program--would begin to remove the implicit too-easy-to-fail subsidies provided these bank holding companies and their shadow banking operations. Because again, entities other than the commercial banks, in my view and the view of the Dallas Fed, have inappropriately benefited from an implicit safety net. And that safety net is still in place. Russ: Yeah, I know.

18:17 Russ: So, let's take an example of an actual institution. I'll use one with an actual name, and you can change it to XYZ Bank if you'd like. But I'm going to use the example of Citibank. Citibank, I can go and I can make a deposit and have a checking account there and have a savings account. And that currently is FDIC-protected. What would change? What parts of these complex institutions would not be protected that currently or that were, say, in 2008? Guest: Well, if my memory is correct, in mid-2012, so a year ago, Citigroup had total non-deposit liabilities of over $800 billion. By the way, that's 5.2% of GDP (Gross Domestic Product); that's a key indicator, but it's an interesting indicator. They had over 3500 subsidiaries and they operated in 93 countries. So $816 billion in non-deposit liabilities. So, remember, under our proposal, [?] only the commercial bank; so the deposit liabilities would have access to the deposit insurance provided by the FDIC. Discount window loans provided by the Federal Reserve would be limited only to that commercial banking operation. So, those other subsidiaries--and by the way, Citigroup has made significant progress in shedding a lot, but at that time--I'm speaking from memory here, and I know those numbers pretty well--all those total nonbank liabilities, over $800 billion, would not be subject to the safety net. And the two features of the safety net would explicitly by statute have become, under our proposal, unavailable to any of those affiliates or special investment vehicles or other obligations of the parent holding company, which I'll refer to as XYZ Bank. Russ: So, the only problem I have with that--and by the way, I think it's a great idea. We'll talk about some of the other plusses and minuses of it in a minute, as well as the competing ideas for making this problem better. But it's kind of the world we lived in in 2006, 2007, 2003. In theory, JPMorgan Chase didn't get FDIC insurance for its activities. Goldman Sachs didn't have insurance on AIG. They thought they kind of did, sort of, maybe, which was they had some Credit Default Swaps to protect them; they could at least say they were protected; but of course those probably would have fallen apart if AIG had been allowed to go through market discipline. And of course those banks wouldn't be allowed to go to the Lender of Last Resort window of the Fed because they are not commercial banks. But they were quickly converted into commercial banks on paper so they could play in the Fed's sandbox. Guest: You're right. Goldman Sachs petitioned us and became a bank holding company. Russ: So, why would this idea, which is basically, 'I'm not going to be naughty any more; I'm going to be a good boy and I'm not going to reward you for your malfeasance banking community'--why would that statute be enforced? Guest: Well, I think it would have to be enforced in practice. And let's not use the word--well, you could use 'malfeasance,' but at least 'misfeasance.' Russ: Sorry. That was a bad choice. I agree. Guest: I've been strong but I don't want to be rude. I think misfeasance and just bad management. So, why should the U.S. taxpayer compensate them for bad decisions? I think it's fascinating. Goldman Sachs came to us, to the Federal Reserve, wanting to become a bank holding company. And then as soon as we got through the process of the crisis, they wanted to shed that status. I think that in and of itself--again, these aren't bad people. They are doing what's best to preserve their franchise. That's the way the system works. But I find it of interest that that was the conduct that they pursued. And if you bring them in to becoming a bank holding company then you are providing this kind of unlimited protection. Now, the way the system has changed under Dodd-Frank is you've created this special body that is chaired by the Secretary of the Treasury that oversees systemically important financial institutions--SIFIs. As you know, my little joke, it sounds like something; SIFIs sounds like you contract through bad behavior. But the point is, that committee--the Chairman of the Federal Reserve serves on that committee and plays a very important role, but it is ultimately chaired by the Secretary of the Treasury. And whether you are a Republican or a Democrat, if the Secretary of the Treasury is facing an institution that is still too large, gets itself into trouble, I doubt any President, Republican or Democrat, is going to let that Secretary of the Treasury allow that institution to fail. So, I don't believe the problem has been solved. Russ: How would your solution make that any better? And let me give you an example of why I worry about it. The 'F' in Fannie Mae and Freddie Mac, that first letter, stands for 'Federal.' But of course on paper, in theory--actually, I think by Congressional dictate-the Congress disavowed any 'F' part of Fannie or Freddie. When they would talk about Fannie and Freddie--and I say 'talk'--when they would have legislation about Fannie and Freddie they would always have the disclaimer that nothing about Fannie and Freddie, the fact that the word 'Federal' was in their name, should be taken to mean that they would be rescued in the event that there was a problem. Of course they were rescued. That statement, which was not quite a statute, but it was an explicit statement, was taken by investors with a wink. And I worry that your solution won't have the same thing. You'll sign that disclaimer, that beautiful, nice, simple warning statement that you understand that your money is at risk there; but you'd be winking when you signed it. Guest: Well, that's always a risk. And I think you just have to have strict implementation. You have to have, as with anything--the way you gain credibility is to practice. Practice as it's been instituted so far has been to bail people out. That's what we saw. Or to merge them into something larger, which then becomes even more too big--if there is such a word--to fail. And the measures that have been taken to address it is a law that is so complicated that we estimate--and others have estimated as well--takes some 24-million men-and-women-hours just to interpret and implement. So in the end it comes down to what you state and the conviction with which you state it. And then the way you follow through and practice it over time. I hope these institutions don't get into trouble. I have seen--you mentioned a specific bank earlier, Citi. They've actually taken action to shed some of their subsidiaries outside of the banking field. I expect that if you state with conviction what we have suggested and you make it clear and it is passed and dealt with by the Congress, whether it's put forward by Elizabeth Warren or it's put forward by the Republican Senator from Louisiana, whoever it may be, the market would begin to price in some of the risks that we actually see. And then we'd have to see what ensues. But again, you don't know until push comes to shove. And all I can tell you right now is despite the honest and good and sincere efforts of the new legislation, I don't believe the system is really significantly changed. We do at the Federal Reserve have more oversight and regulation; we embed more people in these institutions. We have a very strong individual and our governance structure--Dan Tarullo, who is eager to make sure that capital requirements are tight, that liquidity requirements are significant. But in the end you still have these very large, behemoth institutions that put the taxpayer at risk.

26:54 Russ: I'm going to make a suggestion that is going to sound like a joke. It's not a joke. I want an honest response. It seems to me that one way to improve the likelihood that these promises would be kept by policymakers and that the expectations would be set for the players--the lenders and the investors involved--I think it would be interesting to think about having a public ceremony where investors of a certain magnitude--so let's say, a bank, a financial institution lending to another financial institution, which is very common, essentially in the overnight market, which part of the problem we get into is you have, say, Citi or J.P. Morgan Chase financing activities by the other. I think a public ceremony where you sign that warning statement and said, 'We recognize that we, by making this investment put our money and those of our investors at risk, and we will not accept money from the Federal government, and we will not accept a bailout,' would at least increase the chances that there would be some shame and other costs--humiliation--that might help it being enforced. Guest: Yeah. It's interesting. In my district, after TARP [Troubled Asset Relief Program] came out, of the second largest bank in this Federal Reserve district, Frost Bank, took out ads that were extremely effective, and billboards, saying 'We turn down and don't need government money.' And it helped them grow market share. So, yours is not a silly idea. And you saw that elsewhere in the country, by the way. Russ: Well, Ford, for a while, a very short while, bragged about the fact that they did not get rescued like GM (General Motors) and Chrysler; and I think there was political pressure on them not to brag about it. And they stopped. Guest: Well, Texans don't bend very much under political pressure. Mr. Evans, who I think was the CEO (Chief Executive Officer) of Frost, was very pugnacious about it.

29:02 Russ: Let's talk about some of the other proposals. The two that come to mind are larger capital requirements, which a number of EconTalk guests have advocated for in the past. And also capping the size of banks is a way of avoiding the too-big-to-fail, so putting some sort of cap. What do you feel about those solutions, so-called solutions? Guest: The latter is interesting but I personally want to be careful that we have the least amount of government intervention as possible and have the most market-driven solution. I believe our proposal would lead to more market-driven rationalization, so I would hope it would do that. And I kind of worry about doing things by government fiat. That's just a personal concern that I have. The former proposal is interesting and not unimportant, perhaps necessary, but I don't believe sufficient. When you have a panic or a liquidity run, capital cushions, I'm not sure they are sufficient or could ever really be sufficient to prevent the panic from happening. If someone whispers that the Roberts Bank is going under and it begins to gain credence, you can be as well capitalized as you can imagine. But if you are depending on short-term funding, you can be swamped. This is one of the reasons why, again, the Federal Reserve, and as articulated by Governor Tarullo, has expressed concern about the liquidity profile of many of these institutions and the need to tighten up other requirements for that. It's also one of the reasons that some have proposed, particularly when they take risks with derivatives--the larger the book gets, they need to be subject to higher margins. And I find that somewhat attractive. But I don't think it solves the problem. The problem is you have institutions, a handful, that by the way comprise 0.2% of all the banks in the country--that's 2 tenths of 1 percent--but that are too big to manage. The scale and scope of these institutions are too big to understand. They are too complex. Even, I'm convinced, senior management does not know what is going on in those institutions. So, you can have big capital cushions; that's the approach that's been taken so far. You certainly should have, the bigger their risk is just as you would with a hedge fund, anybody else, you should have higher margin requirements, as they become larger and larger. That would ensure some discipline. But in the end the ultimate root problem is scale and scope. And if you are so big, it's very hard to get back to the basic principle of banking, which is, know your customer, know your risk. And that's what I would like to see achieved. Russ: Before I move on to monetary policy, I want to make sure I've got the full range of what you would advocate. We've talked about two parts. Only the depository, commercial bank part of any institution would be FDIC insured and would have access to the discount window of the Fed. The second part is that people who were creditors of those institutions, these large institutions, would concede on paper and sign a warning that they had received--kind of like when you leave the emergency room; they don't want you to leave and say, look, I'm going against medical advice. You make them sign something that says: It's my money that's at risk and I'm not going to get access to the taxpayer's money. Two questions: Is there a third part to the proposal, and the side-question is on the part about the discount window: how would you monitor that? Guest: First of all, we have 12 Federal Reserve Banks; they all operate discount windows, so it's pretty easy for the Federal Reserve to monitor that. They are the ones that extend the credit. Russ: But how would you decide "who gets it"? Guest: Well, you have supervision, regulatory authority; and you'd make it clear that any violation of this would lead to a cutoff of access to the discount window. I don't think it's that complicated. But that would be the rule of the requirement, and somebody that violated it would be violating the rule of the requirement. It would be a regulatory infraction, and there would be discipline. So, that is our proposal. It is in essence a two-part proposal. The remaining issue is: do you give any government shove in terms of what you suggested, which is limiting size? And although it was suggested that we were--and this is what the banking lobby likes to put out--'the Dallas Fed was saying any bank over $250 billion would be prohibited'--that is not our suggestion and has never been our suggestion. So the question is, does the government need to give a little shove to the marketplace, if you believe governments can give a shove to the marketplace, to make sure we indeed end up with a group of institutions that are too small to save, rather than too big to fail? I'd rather see the market exert its discipline through the two-part proposal we've made before making a judgment as to what other push you might need in terms of government intervention to possibly realign incentives or to reestablish a competitive landscape and a level playing field. But I'm not willing at this point to suggest that step. Russ: My view on it is that until there is a Presidential candidate who makes this a central issue, who stands on this promise, who, after winning, makes it clear that his or her credibility depends on honoring the statute you are talking about, which if it is ever passed, then I think you could get somewhere. Otherwise I worry you get more back in terms of, well, we had to do it because the whole country was going to be destroyed, etc. But it's imaginable that such a political change could occur. And my view has always been that unless there is a simple policy that Main Street understands, it's unlikely any president will get behind any complex, say, Basel III-style regulatory regime. Guest: You're right. Russ: So I think the simplicity of your idea is what recommends it. Guest: May I just add one more thing in terms of that consideration? I was amazed that neither candidate in the last Presidential election picked up this ball. Let me give you a number that's indicative of how this would cut across partisan lines. I engaged in an IQSquared (IntelligenceSquared) debate in New York and in the audience itself--because you know these things are recorded--we garnered 49% of the vote. Russ: Before or after? Guest: After. Russ: In support of your position. Guest: Yes. But here's the important part. Those are the people sitting in the audience, of which I noticed several familiar faces from the clearing house. In fact one came up to me afterwards; I had referred to XYZ Bank; the question had to do with J.P. Morgan; and he said, 'By the way, I'm the Chief Financial Officer of J.P. Morgan.' So how do you think he voted? Now, when you look at the online voting from that debate--that is all the voters--83% voted for our proposal; 17% voted against. Again, as I said earlier, you have Elizabeth Warren, not considered a conservative by any means, proposing exactly what Senator Vitter from Louisiana, who is, say, Tea Party conservative. So this does kind of cut across lines. It's an issue that can actually unify Congress, when they can't agree on anything. And I think it is highly politically palatable. Setting aside the politics, because I am a central banker, not a politician, the point is that it needs to be done. Russ: Well, I think the frightening thing is that, you asked it as a rhetorical--I think you said as a statement it's a surprising thing neither candidate brought it up. And I think we know the reason. And the reason is money. And the reason is where their bread is buttered. And till that changes--I'm a big fan of shame, but that's not what this conversation is about. So let's move on. Guest: Okay.

37:51 Russ: Let's turn to monetary policy. Give me your--and you are not a retired central banker. You are very active. You are the President of the Dallas Fed, one of the 12 regional banks; and if I understand it correctly you are going to be a voting member of the Federal Open Market Committee starting some time soon. Guest: That's right; January. Russ: So, I'd like your assessment, as openly as you can give it, as to the last 5 years of monetary policy. It's been an extraordinary time, unparalleled really, in terms of the Fed's balance sheet growth and in some of the discretion that's taken place. What do you think of that? Guest: Well, we have ventured into territory that no central bank has been in before. Others have followed suit. But we have been in the lead. The intentions are sincere; that is, to lift up the economy from a seemingly endemic low-growth period, help, given the franchise we've been given by Congress, which is so-called dual mandate, which means we are responsible for price stability but also achieving--and by the way, the phraseology in Congressional language of the amended Federal Reserve Act of 1978 is "shall maintain long-run growth of monitoring credit aggregates commensurate with the economy's long-run potential", increased production, so it's to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates. Russ: Piece of cake. Guest: That's right. Now the key operative word, and my colleague Charles Plosser made an excellent speech the other day on this is 'long run.' But we did have to go to work, as central banks do, as lender of last resort, as I mentioned earlier. During a crisis you open the floodgates; you are supposed to lend against good collateral. We actually did patch together the system when everything failed--from overnight bank lending to money market funds--excuse me, commercial paper market, etc. We did our job. Then we went on to Quantitative Easing, after interest rates were cut to zero. And just to be clear, I was against cutting interest rates to zero, because the question is what bullets do you fire next? Well, the bullets that were pulled out of the holster was Quantitative Easing. We purchased mortgage-backed securities to get the market started. It was an asset allocation decision. I have argued, others have argued, that the Federal Reserve should not be involved in that business of deciding which assets you should invest in, but I admit I supported the very first tranche of our mortgage-backed securities to get that market turned. And we did. But we are now buying $85 billion a month in Treasuries and mortgage-backed securities. I have been against that program. I'll continue to be against that program, and mainly because I don't think the benefits are equal to the costs of our having printed so much money and expanded our balance sheet to over $4.2 trillion. It was a little less than $900 billion before the Crisis started. And now we have a significant portfolio. When we buy a bond, a Treasury bond, or Treasury note, and when we buy a mortgage-backed security, we pay for it; and that puts money out in the system. That money has come back to us in terms of excess reserves. So it's not being lent out, either because there is not sufficient demand for it or because bankers are slowly getting back to have their confidence to lend. Whatever the reason, it's being stored up as excess reserves. And if you think in terms of the language of our amended Federal Reserve Act of 1978, we're required to think in the long term. And what worries me about the long term is we do have and we've talked about and we have an exit strategy to deal with this, but it's a theoretical exit strategy. It's never been done before. And I'm worried about the long-term consequences of having all that money sitting out on the sidelines. These are in depository institutions as well as significant amounts of money sitting in private equity firms and sitting in hedge funds, etc., outside our purview. That's a lot of tender. If velocity were to pick up, how do we tamp it down so that it doesn't lead to inflationary impulses? Right now inflation is not an issue. But our charge, given to us by the Congress, says long run, long run, long run. And that's what I'm worried about. Those are the costs that I'm worried about. And the benefits? Well, I'll be blunt about this. Mr. Druckenmiller said this on television the other day: this is great for rich people; it's great for Warren Buffett. Bless his heart, he's a good investor. Good for Mr. Druckenmiller and others, they get money for free. It hasn't done what we wanted it to do, which is lead to greater job creation for the two middle income quartiles. Some people refer to the middle class--I don't like the word 'class' because I believe America is a classless society. But the middle income quartiles--other than in Texas, by the way--for the last 10 years have had job destruction, not job creation. And that's who we should be working for as a central bank. We work for the American people, not for the rich. Is that outspoken enough for you? Russ: Yeah, that's good. I like the honesty. Much appreciated. Let me ask a naive question: how is there still $85 billion of stuff to buy every month? Don't they have--doesn't the Fed have most of it? Is there still--and who are you buying it from? Who is still holding mortgage-backed securities that they haven't already sold to the Fed? Guest: Well, that's a great question. It's a question of stock and flow. But in terms of flow we are fast approaching 100% of the gross issuance of mortgage-backed securities. And we have about 35% of the stock of U.S. Treasuries. Now, this will sound silly to you, but remember I'm a Texan and I do remember the Hunt brothers; and it's one thing to buy up silver and then to try to sell it. Now, obviously Treasuries are much more liquid, mortgage-backed securities, much more liquid. But what I've talked about at the table and am concerned about: it's different when you are a buyer. When you are a seller then you are on the other side of the market. And if you listen carefully to what you hear, market commentators and so on, it's hard to hear anybody that's really in favor of buying U.S. Treasuries here. We've driven yields to--even though the yield curve has sharpened recently, steepened, we did drive yields across the curve through our Operation Twist and our expansion of the duration of our portfolio, to the lowest rates in, what, 237 years of U.S. history. Lowest rates in memory, certainly. Which direction do you go from here? And how long can you do that? How long can you--even Chairman Bernanke and others have said this doesn't go on indefinitely. And the markets have become so significantly dependent on what is the Fed doing. But I worry as we are just viewed as the ultimate solution. That's not the role central bankers should play. Even Keynes said: we should be thought of as dentists; you only go to us if you need us. But instead we are playing a central role in American capitalism here, and in market-driven side of American capitalism, and I think it's a dangerous place to be. It puts us in jeopardy. So, I'm very worried about this, and I expect that my own voting behavior will reflect this concern that I just stated. I don't think these are programs that should be continued, and I worry about the fact that we've already painted ourselves into a corner which is going to be very hard to get out of.

46:19 Russ: So, why do you think the Federal Reserve is paying interest on reserves? One of the challenges of this, stranger parts of this conversation and this episode that we are talking about is that those reserves, those excess reserves, banks are holding much more at Federal Reserve accounts than they are required to by law. They are required by law to hold a certain amount. They have massively more than that sitting at the Fed, not being lent out, not being invested. Now, this idea that somehow low interest rates are going to make it more attractive to borrow and invest is only true if there are good opportunities. Usually there are a lot of opportunities at a quarter percent interest or .5% interest. Why do you think banks aren't lending? Why are they not lending, and do you think that the payment of interest on reserves is part of the problem or irrelevant? Guest: Well, I don't think any banker is happy getting 25/100ths of one percent--that's per year--rather than lending it out at 4 or 3 or 6%. So bankers want to make loans. That's what they are paid to do; that's what they want to do. There either is insufficient demand--which I think is the main thing right now--or there are only, as we see from our senior loan surveys of senior bank officers, there's an increased willingness to take risk. And by the way, some of the risk that's being taken raises some question marks: no-covenant lending, highly risky, particularly by the largest institutions. And we are constantly getting reports from smaller banks and regional banks that the offers being made out there are considered by them to be imprudent. So there's a lot of excess liquidity in the system. I don't think 25 basis points is the reason they are keeping it with us. They are keeping it with us because there is a lot of liquidity out there. I'll give you and example of a very large company that I just spoke with this morning. I survey CEOs on my own; I do it constantly. And I do it across the country, not just in my own Federal Reserve district. So this is a major company outside of my district. So, for 2013-2014, their CAPEX, that is Capital Plan Expansion, for which they hire people, in this very large company's case, is a little over $30 billion. They have placed $40 billion--so more than CAPEX--to work by borrowing cheap to buy back their stock and increase their dividend payment to hold up their stock price. Something's wrong with this picture. Now, their balance sheet is in great shape. And one of the things that's come out of this Quantitative Easing and also the zero interest rate, what's called ZIRP, zero interest-rate policy, has been that U.S. companies are now, their balance sheets are as fit and as top and as clean and as well-structured as I've ever seen them. In my kids' parlance, they are ripped. They are ready to roll. But there are disincentives and great uncertainties out there, either about final demand or health care insurance or regulatory excess or fiscal policy--what will their taxes be, what will the spending be?--that they are disincented [sic] from actually investing in job creation. And many of them have learned that they are so productive and can produce the same amount of goods and services with lesser amounts of people thanks to harnessing IT (information technology)--the game seems to have changed. And there is less need for the constant credit that we are creating in the market system. This is one of the reasons that I don't think we need to continue buying $85 billion. We can reduce that amount. In my opinion, we should reduce it over a clear time frame that's stated in public it's going to end, because there is an enormous amount of excess liquidity throughout the system. That's a longer answer than you wanted, but I wanted to lay it all out on the table. Russ: You've reminded me of something I meant to ask you earlier. With that Fed balance sheet of $4-plus trillion dollars, all said, of assets--a lot of it is mortgage-backed securities, some of it is not--you made a reference to the Hunt brothers, an historic episode where they tried to corner the silver market. So, congrats to the Fed. They have cornered the MBS market, the mortgage-backed securities market. What's that stuff worth? No one talks about--well, they do occasionally, but there's very little public discussion of what kind of gains and losses that the Fed will take on its portfolio. It's usually--it was often claimed in the early days, 'Well, they could make money on it. They could actually make a profit.' I don't hear any of that talk. Guest: Well we did. Well, actually we did. And actually the Chairman has talked about this. I've talked about it, and others. We've returned to the taxpayer, because we are a profit-making institution, but we don't pay our profits out to the public shareholders. We do have banks that are our shareholders, the 12 Federal Reserve banks. We pay them a preferred[?] dividend. And then we pay what would be in a normal business a profit to the Federal government through the U.S. Treasury. So we've returned over $300 billion, as the Chairman has said, and I've said and others have said, to the taxpayer over the last 3 years. That's what happens when interest rates go down and you have a portfolio. A lot of it has been driven by our Federal Reserve New York desk operation, which trades on behalf of all 12 Federal Reserve banks in the system. The question that you raise is an interesting question, which is, if it goes in reverse and interest rates go up because the economy gets stronger or because, in the worst case, people begin to impute some potential inflation--that would be the bad outcome; the good outcome is the economy gets stronger--you are holding a portfolio with an average duration which is out on the yield curve and you begin to take a loss. And just so your listeners understand, the way it's done on the accounting, this business, is it's booked as a deferred asset to the Treasury. Question: Will Congress remember that we made 3 years of substantial profits, if, in fact, interest rates go up, for whatever reason, and the market value of our portfolio declines? I somewhat disrespectfully suggest that Congress has the memory of fish. And fish have no memory. So my suspicion is that if something were to go wrong, then they would turn on us once again, as they did very harshly during the whole TARP and other episodes, put us in the spotlight and say, You lost money for the taxpayer. They'll forget how much money we've made. So I think it's important that the Chairperson of the Federal Reserve and Federal Reserve Presidents like me, remind the public that we did make money for the taxpayer. In fact, we are probably the only people that did make money for the taxpayer. And it's not insignificant. Russ: Well, but--there's some accounting issues on how you measure that, obviously, and what opportunity cost you attribute to the funds, which is ignored usually in those measures. But the part I'm wondering about is a simpler question. The underlying assets of those mortgage-backed securities and what the prices that the Fed paid for them. How is that money going to get reclaimed? Are all of those mortgages that are in those securities good? Are they all going to be paid back? The answer is no. Isn't there going to be a potentially large capital loss? Or maybe a gain? Guest: Well, first of all the accounting for those is very interesting. They are paid down over time. So it's a complex matter. It would take me a couple of days to walk you through my old experience of how [?] been invested in those when I ran a hedge fund and I ran an investment firm. And of course we can sit on them till maturity, and then you don't realize the loss. Your question is the underlying credit-worthiness, and I'm very confident that, again, these are--you go back to Freddie and you back to Fannie and you go to Sallie Mae--these are securities backed by those institutions. Assuming that those institutions are sound, and under the law, we are allowed to buy those securities. We are only allowed to buy two securities. We are unlike the, say, the Bank of Japan that can buy anything. Only U.S. Treasuries or U.S. agencies. And those are the securities that we buy. One more thing, if I may add. Russ: Go ahead. Guest: We are the only business and the only government, quasi-government, institution that posts its balance sheet in terms of what its holdings are, on the internet, every week. So someone can go in, take a look at what we own. They can price them accordingly. And they get a good sense of what the market value is. Even though not everything we hold is [?] at market value. Russ: I have to say, Richard, you remind me of when a friend will say to me--oh, it's easy to install those lights. It's simple. In my house. You don't have to hire somebody. I'm thinking, yeah, but not me. So it may be on the web, but for most American citizens-- Guest: I've changed all my lights this weekend, so you're right; it's not easy. I had to call in a professional to help me with three of them. Russ: Congrats. But I think for most people that task on the web is pretty daunting. It's daunting for me, and I'm an economist.