Fed Chairmen and Presidents: Roundtable with Roger Kubarych and Richard Whalen

In this issue of The IRA, we turn to two veteran observers of the Fed and the US political process to get some perspective on the financial crisis and the policy makers who have arguably caused much of the present economic difficulty.

Roger M. Kubarych is Chief US Economist of UniCredit Global Research, part of UniCredit Markets and Investment Banking. He joined HVB Americas Inc., now part of UniCredit Group, in July 2001 with responsibility for advising management and clients on economic, financial market, and policy developments with significant implications for banking and investment decisions. He is also the Henry Kaufman Adjunct Senior Fellow for International Economics and Finance at the Council on Foreign Relations. He has published two books: Stress Testing the System: Simulating the Global Consequences of the Next Financial Crisis (2001) and Foreign Exchange Markets in the United States (1980).

Richard J. Whalen is an author and consultant who lives in New York. During his tenure at Fortune, Whalen wrote The Founding Father: The Story of Joseph P. Kennedy. His critically acclaimed book was on the New York Times’ bestseller list for more than a year. He served as a special assistant in Richard M. Nixon’s successful 1968 presidential campaign and as senior consultant to Secretary of State William Rogers in 1969-71, and then left government to launch his own political and economic intelligence and consulting firm. In 1972, Whalen wrote a prophetic study of the Nixon presidency, Catch the Falling Flag, A Republican’s Challenge to His Party, published a month before the Watergate break-in. A senior policy adviser to Ronald Reagan from 1975 through the 1980 presidential campaign, Whalen was an informal adviser thereafter. IRA co-founder Christopher Whalen, who conducted this interview, is his eldest child.

The IRA: So Roger, we love to read your stuff, but don’t see it often enough.

Kubarych: I get to write a lot but most of what I write is internal and goes to clients and management. Henry Kaufman taught me that a little exclusivity is a good thing. Henry, by the way, still runs Henry Kaufman & Co., still has consulting clients, still finds time to help his sons with their businesses, still writes and still disagrees with power, including the powers on some of the boards on which he serves.

Whalen: He is much missed from center stage, where he operated for many years. He and Paul Volcker and people of that vintage have a toughness of mind that is missing from the plastic people we find in politics in more recent years.

The IRA: Yesterday you were talking about this issue of toughness and about President Herbert Hoover, who you spoke of in glowing terms. What did you mean by that? His memoirs is perfectly constructed and organized, like a report to the Congress, the product of a very orderly and disciplined mind.

Whalen: He had the foresight to see the need to create the Reconstruction Finance Corporation in 1928. In my view, the Bush Administration and the Congress should be recreating the RFC now so that the next president has the tools to deal with the implosion in real estate markets, recapitalizing the banks and reviving economic activity generally. The fact that these structures were in place when FDR took office was a big advantage.

Kubarych: And the RFC actually got going in 1933 in a serious way.

Whalen: Hoover saw what was coming but he did not understand the modern state and modern finance well enough to realize that time was running out and would overcome him. Secretary Hank Paulson and the Bush White House still do not understand that time is running out and that we need to immediately revive the RFC model to deal with the looming economic collapse. This effort must start immediately after Election Day. Hoover was part of that lengthy transition where the President was elected in November but sworn in the following March, now we can hardly even afford to wait till January.

Kubarych: There are a lot of people who foresee things and, basically, sometimes it’s almost accidental. But nobody likes to pay attention to low probability, high-cost events. We’ve see this over and over again. And so you bring up to somebody in authority that if this happens and this happens, then this will be the result. It isn’t that you are dismissed as being adolescent or puerile, you’re just too early. There’s a great story that Chuck Brunie has written about Milton Friedman, for whom he managed money. And Brunie talks of once asking Milton that as one of the most distinguished economists in the world why he needed someone like Chuck to manage his money. And Dr. Friedman replied, “Chuck, I see things too early.”

The IRA: We were showing people the skew in the results for the banking industry back in 2004 and 2005, when loss rates were clearly below any rational level of “normalcy,” but nobody wanted to hear it. Now the once draconian assumptions in our economic capital model look tame vs. the headlines.

Kubarych: There were quite a few who saw the danger signs. I mention you folks at IRA were early, so were my friend and debating partner Bob Shiller, Jim Grant, Nouriel Roubini. All of my favorite benchmarks saw the crisis coming. They all saw it coming.

Whalen: Jim Grant is one of my favorites as well. I remember once being berated by Larry Kudlow after writing a piece for the Washington Post about the trouble coming for the banks. Larry who was still kicking around OMB said “stop worrying about the banks, that’s not how we’re going to see trouble.” But it was the mid-1980s and I speculated in real estate in Washington. You could see the froth. It’s tough to be early and to get notice for being early, but once you have a hard fact upon which to stake your thesis, then you start to collect your due. And you start to build a chain of evidence to a conclusion that you could have given them years before.

Kubarych: That raises an issue, namely New Century Financial and its failure in February 2007. It provided incontrovertible evidence, after some rumbling in the hilltops, of an earthquake in the mortgage securities market. A meeting of all of the major investment houses occurs at the Federal Reserve in New York. One of the great thinkers of Wall Street lays out a scenario of how New Century was terrible and had grave consequences for the markets. This sage was patted on the head and praised for his imagination. “We’ll get back to you,” was the collective response from the heads of the major dealers and nothing happened. In fact, quite the opposite happened from what you might expect. You can detect a whiff of complacency in the testimony by Ben Bernanke to the Joint Economic Committee in March 28, 2007:

http://www.federalreserve.gov/newsevents/testimony/bernanke20070328a.htm

“Although the turmoil in the subprime mortgage market has created severe financial problems for many individuals and families, the implications of these developments for the housing market as a whole are less clear. The ongoing tightening of lending standards, although an appropriate market response, will reduce somewhat the effective demand for housing, and foreclosed properties will add to the inventories of unsold homes. At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained.”

The IRA: What is interesting about your comment is that Chuck Schumer (D-NY) and the other Democrats on the Joint Economic Committee actually were sounding a pretty loud alarm regarding subprime and the collapse of the mortgage sector in 2007.

Kubarych: Yes and here we had incontrovertible evidence that something fundamental had changed. You did not need to be an insider to see this. It was not on the front pages of the major newspapers, but New Century, one of the biggest subprime mortgage originators, had gone bankrupt, as two dozen or so smaller firms had already done. Then you had Ned Gramlich’s book coming out, Booms and Busts: The Case of Subprime Mortgages, around the same time.

The IRA: Another man who was very right, the late Edward Gramlich. His paper calling for swift action to deal with the mortgage crisis two years ago went largely unheeded. Click here to see the complete collection of the Gramlich paper and related materials from the Urban Institute.

Kubarych: I had been saying to our clients “this is it” and a lot of other analysts were saying similar things. But this wasn’t quite “it”. It took a very different type of event, almost totally unrelated, namely the Bear Stearns hedge funds that went bad, to shake people into awareness of the threat. But that was a long time between February and July of 2007, when things might have been done to address this crisis preemptively, prospectively even prophylactically, that weren’t done. If you are giving grades to officials last year, you have to assign an incomplete for the way they handled the New Century crisis and the purposeful decision to ignore this warning and say in effect that “this does not mean anything.”

The IRA: The denial is always the same.

Whalen: The Bear hedge funds were internal. How much did outsiders really know what their failure really meant? What disclosure was available to investors?

The IRA: Hedge fund disclosure varies with the particular fund.

Kubarych: I’m in a hedge fund, a young guy runs it. I can see every trade that he makes. I’ve been with him for eight years and he’s made a lot of money for me. He tends to be too early as well, but little by little as you get older you learn how to benefit from being too early. I know some of the other investors in our fund and we chat frequently about developments. I am a big believer in hedge funds being the structure that works best for the serious, active investor. And our fund has very little leverage. The maximum leverage we ever ran was 2:1.

The IRA: But you are actively involved in monitoring the performance of that fund. Few investors in hedge funds maintain that level of diligence consistently. But we agree that a fund type vehicle, perhaps operating as a broker-dealer or even a bank, is the best choice for the future in terms of a low-risk investment scenarios. When you look at the State of New York preparing to regulate writers of credit default swaps against hedged, long-bond positions, it should be clear to everyone that a new regime regarding leverage is coming. The carnage in the cash markets may do the job even before NY Insurance Commissioner Eric Dinalo gets started. The fact is that many funds were writing insurance in CDS with no capital and now the dealers have to take back these positions because the “assets” of a hedge fund are mostly owned by the dealer. Your 2:1 hedge fund example is the exception to the rule in the world of two and 20.

Kubarych: Writing CDS is a form of options writing and should be considered just as dangerous. You are writing naked put options…

The IRA: A friend in the market calls them “barrier options” but obviously options written with little or no permanent capital or reserves backing the ability to pay. With or without a central clearing house, CDS looks to us like is a bomb waiting to explode – or rather implode back unto the “prime” broker-dealers as the notional obligations become real cash positions.

Kubarych: Well, we trust the big guys to do it right and make the correct calls on collateral and margin. But fortunately we do have a system that was put in place by DTCC called Deriv/SERV that is now a computerized matching system and is a step toward fully electronic clearing of CDS. It’s like the process of conversion to electronic clearing that occurred with mortgage-backed securities in the early 1980s. However, not everything in the OTC derivatives world has been dematerialized within DTCC. Over 90% of the global flow is now processed by DTCC and over 3 million CDS contracts are dematerialized within the Trade Warehouse. In addition, the Warehouse allows firms to process Credit Events – for example, the major defaults such as Fannie & Freddie or Lehman – on a netted down basis. Despite the many large figures cited about outstanding Lehman CDS contracts, the net credit event processed was less than $6 billion. This was settled among the largest dealers automatically through CLS – just as daily Forex is settled.

The IRA: We discussed the Lehman CDS auction in our last comment (“In the Fog of Volatility, the Notional Becomes Payable”). Has this move to electronic settlement allowed parties to extinguish contracts before the original termination date?

Kubarych: Yes, it’s called ‘tearing up’ and has now been standardized. But part of the problem we have faced in moving the OTC market to a DTCC framework is that the IT departments of the biggest banks have been starved for years, decades in some cases. If I were the Regulator in Chief, the first thing I would do is have the CEO of the top firms come into the office and answer the following question: do you have real-time knowledge of your CDS position? If the answer was no, then no bonuses for anybody on your management team. The money instead goes to IT until the answer is yes.

Whalen: I am completely unaware of this not being from the world of finance, but I have this vague notion of the derivatives markets formed by talking to people like Christopher and you Roger that this monstrous pseudo market is comprised of billions of piece of paper floating around and autonomous individuals can write positions with little or no capital.

The IRA: You are speaking of the front-office issue, namely who is doing the trades and talking the risk. Roger was describing the efforts to get the back office into the later 20th Century by immobilizing these transactions within DTCC’s vaults.

Kubarych: This is about plumbing first and foremost, which is now state of the art, top quality brass. And a lot of the plumbing in the original market was this sort of lead which leaked. Why did the OTC derivative markets have such primitive infrastructure? Because the people who run the largest banks are cheap and they cut pennies in back-office expenses that have cost them many dollars.

Whalen: Reconstructing a narrative or a chain of events is always useful when preparing to write a long piece for Fortune, but why is it that something as grave as the failure of the Bear Stearns hedge funds not send a traumatic shock through the entire community that said “If we did anything like what the Bear funds are doing, then we’re in trouble too.”

The IRA: There was quite a reaction in the risk community, among people who deploy assets in funds or trade with funds. There was a reaction, but the larger investment community did not want to hear such messages. Even a year ago, people were still pretty strongly in denial or completely clueless. For example, last summer one of the largest real estate developers in New York called me and confessed to having re-read the prospectus for a JPMorgan (NYSE:JPM) money market funds. He said “They can buy anything.” So in a period of hours, large sums of money were pulled out of this sexier JPM fund and into a Treasury-only fund also with JPM. A few other clients of the “party of the first part” followed suit, causing these two JPM funds to see enough turnover to demand attention from senior management. Several other funds visibly broke the buck during this period, so people who pay attention and read prospectuses knew.

Whalen: So what happened at Bear Stearns in July 2007 and why did nobody at the Fed or Treasury sound the alarm? To me, it looks like we waited so long to sound the alarm that we’re now forced to scramble from one expediency to the next, with little thought or design. The delay Roger describes is very costly indeed.

Kubarych: Well first you had the Paribas fund seize up, where they blocked withdrawals, which was like the second shoe dropping. And then shoes started dropping in every direction and these were hobnail boots, not tennis shoes. We had the reaction of the Fed in August 2007 trying to get banks going to the discount window. Then there were further liquidity initiatives and finally a rate cut. But then something happened that was very bad. The Fed split between the academics, you might call them the “inflation firsters.” I would call them quasi-Europeans. And the others were the financial market types. They had this collision at the October 2007 FOMC meeting in which they had a very close call to do anything further. And of course the stock market had rallied in reaction to the Fed’s action. Happy days are here again!

The IRA: More of a decade long flight from reality. It’s almost as thought the FOMC was not aware of the magnitude of the credit bubble. Were the anti-inflation hawks wrong to stand their ground?

Kubarych: I am not saying that the “inflation firsters” did anything wrong, but I do say that the financial market caretaker types did not do a good enough job on surveillance. After that we had a very bad period for the markets and Fed Vice Chairman Don Kohn came to the Council on Foreign Relations on the record and basically admitted that you don’t know what a close call that October decision was. Everybody thought naturally they would have to follow through. There was a learning experience for the Fed. Were they behind the curve? Certainly from the point of view of drawing together the entire institution, yes. That consensus within the Fed system was not really reached until March of this year.

The IRA: There have been a lot of very angry opinions expressed in the financial community about what the Fed knew and when certain decisions were made. It has been alleged, for example, that Chairman Bernanke in September 2008 could not get the five votes needed to pass an emergency loan for Lehman Brothers through the Board of Governors, but we just had an insider with strong ties at the Fed debunk that idea. But in any event, allowing the largest dealer of commercial paper in the US fail has left the Fed now in the position of de-facto market maker.

Kubarych: Look, Bush could have gotten non-partisan experts appointed to the Fed’s Board. He did not choose to make those kind of appointments. Instead we got a political appointee and someone coming right out of CapitalOne (NYSE:COF). I like having bankers on the Board, make no mistake, but I like retired bankers who’ve been out of the industry for a couple of years. Picking the executive vice president of a significant industry player raises questions. He was not confirmed, by the way, and his bank is one of the institutions that has just applied for a capital injection under the Paulson bail-out.

The IRA: But don’t you want bankers who “get it” on the Board? Not sure that coming straight out of the CSUITE of a bank is a bad thing so long as the candidate understands that the priorities have changed and that he or she now serves the interests of the United States.

Kubarych: But not active ones. I like retired bankers on the Board. I thought that Fred Schultz was a perfect choice to be vice chairman. One of the great unsung heroes of that era and one of the handful of associates Paul Volcker could talk to without it getting leaked. Schultz and Henry Wallich were two colleagues he could always trust.

Whalen: Paul was an embattled chairman only because he was so honest. I was the liaison between Reagan and Volcker in the late 1970s, self appointed…

Kubarych: Even before Reagan was elected?

Whalen: Yes. I knew Volcker from his days in the Nixon Treasury, he was the number three or four guy. I was part of the Reagan kitchen cabinet and I was looking for ways to help him. I realized that Volcker had a one year head start on Reagan in terms of managing the economy. And nobody else in the Reagan group was paying attention to the politics of the Fed and what the consequences of a v-shaped recession and likely 10-percent unemployment would be. We would have 15% interest rates by that point or would have. I wanted to know the timing of the inevitable recession and what the impact of the huge anti-inflation interest rates would be on the economy. So I would visit Paul every couple of weeks and we would have a frank but cautious exchange. He didn’t give up any secrets and did not need to. I would tell him where we were politically and what we thought was going to happen. He once told me that “People in Washington were telling me very confidently that President Jimmy Carter was going to be re-elected.” I said, “No, it’s over. We’re going to win big.” Then Volcker said something to the effect that Reagan “is just an actor” and he don’t know what to do. I replied that we were planning the first 100 days. That’s why Volcker was so important, because he had been on the job fighting the key economic battle of the time. But at that point when the Fed Funds rate rose to 15% I began to think that I was operating above my pay grade. I was trying to act as a reporter to take this information back and forth between the principals, but those were dire days. I finally urged Volcker to call Reagan and Reagan at once returned the call.

The IRA: Well, you are now an Obama Republican. Do you see any high level communication going on between the current players and the respective candidates? Kudos on suggesting the photo with Obama and Volcker.

Whalen: No, but they are not consulting me.

Kubarych: There is a lot of talent around Obama. He inherited much of the group around Bob Rubin. Dan Tarrulo, Mike Froman. And the Obama inner circle includes people like Bill Bradley and others. This is a team effort. Many of these people supported Bradley in 2000 against Gore and then moved to Obama.

Whalen: But back to the subject, the modern history of the Fed is about the Arthur Burns era, as far as I am concerned. Then comes the confusion after Arthur, when I think to this day that the Carter White House appointed the wrong Bill Miller as chairman. But the real story of the Fed begins with Volcker’s arrival in 1979. He was Arthur Burns hand-picked man at the New York Fed and his preferred successor. As the loneliest and biggest target in town, he really did not have much understanding on Capitol Hill. Congress saw disaster from Jimmy Carter and double-digit interest rates, and most of them had no idea about Reagan, who was seen a washed up movie actor…

The IRA: And not somebody who had been training on the professional speaking circuit for years…

Whalen: And Volcker was doing all of the right things. I talked to him just before he said we’re going to slam rates up to ten percent plus and he did. It helped to jolt people out of the pro-inflation psychology.

The IRA: So how did Volcker get appointed by Carter in the first place?

Kubarych: I worked for Volcker. The Carter people were beginning to realize that Miller was not fitting in. He was a CEO, not an academic collegial guy. It’s like the TV ad with the firemen. The chief says: You want lower interest rates? Hands go up. Done in 15 minutes. So the Carter people approached the late Bob Roosa, of Brown Brothers Harriman and Treasury under-secretary under his pal Jack Kennedy. He said You really should go to Volcker, then president of the Fed of New York. The White House had thought about Volcker before, but decided to go in a different direction. Miller was really one of the few business CEOs who really took all of this corporate governance and responsibility seriously. He did a very fine job as secretary of the Treasury. Miller was not a bad guy, he just did not belong at the Federal Reserve Board.

Whalen: No, they finally found the right spot for him at Treasury.

Kubarych: Tony Solomon, dearly departed mentor, friend, boss, confidant, he was given the job by Mike Blumenthal and Charlie Schultz of convincing Jimmy Carter to appoint Volcker. And Tony Solomon is the example of how anything is possible in politics where someone does not need to get personal credit. That was Tony Solomon. He went to Carter and laid out the case for somebody like Volcker and what was going to happen to the country if we did not have somebody like Volcker. I remember the day he was appointed because his office called and they asked me to meet with a representative of the European Commission who had been on his calendar for months. They told me that Volcker had to go “on a trip.” So I went to his office and we waited hours for Volcker to return and every half hour Anne Poniatowski came in and said “it will be a little bit longer.” I talked to this guy for what seemed like three and a half hours. Finally Volcker comes back apologizing profusely and meets with the visitor for a few minutes. Then he came out and said to me: “Thanks for doing the meeting. We’ve got some work to do in the morning.”

Whalen: That is a great line in a great story.

Kubarych: Volcker would spend a lot of time with his staff preparing for the press conferences and Senate hearings. He was very thorough in his preparation and was very skillful at having members of the group play roles to flesh out the issues. He would have a number of us play him. He would push us to the point where we would stumble, something would click in his mind. Later at the press conference or the hearing, he would skillfully dance around these points, making the tough look remarkably easy. So everybody thought that “this is the guy,” Congress fell for him. He’s imposing but also very amusing, which puts people at ease.

Whalen: He is imposing in many ways. I am fated to be his best friend among conservative Republicans. Like me, he was born in Brooklyn and born a Democratic. I would have probably been better off if I had stayed a Democrat. In that period, the Carter Administration had screwed up so badly and in so many places…

Kubarych: Damn right they had.

The IRA: Very much as today.

Whalen: The Volcker appointment was a source of great unhappiness to all kinds of people. Including Donald T Regan, who had been my first client as a consultant many years earlier when he was CEO at Merrill Lynch. Walter Guzzardi and I had both been assisting managing editors at Fortune. He became the inside guy at Merrill and I was the outside guy at Merrill. We guided Don Regan, who was an arrogant SOB, ex-Marine colonel, through the minefield of creating the SIPC and burying some of the bodies from various Wall Street firm failures that occurred during the 1970s. He called me one day in the 1980s and said “Dick, I’ve been asked to become Secretary of the Treasury.” And I said, “I know, you’re on the list.” So he said, “What should I do?” And I said, “If you want it, take it, but for Christ’s sake stay away from Nancy Reagan and do not mess around with the Fed. Those are my terms if you want my help.” So soon after Volcker has done this brilliant job of saving the economy and making it possible for Reagan to have a successful first term, Regan tried to impose Beryl Sprinkel as the new chairman. I had to go around Don Regan to Senator Paul Laxalt (R-NV) to carry my recommendation to the President. It was just Laxalt, Reagan and the wives at Camp David. I urged Reagan, to call Paul Volcker that Sunday night and ask him to accept reappointment as Chairman of the Fed. I gave Paul Laxalt the telephone number and the call occurred and Volcker stayed on at the Fed until 1987. Laxalt called my that Monday and thanked me for taking the initiative on this. And I thought is this the way these things always happen?

The IRA: Yes, this is how Washington works – or used to work.

Kubarych: Yes, they got Volcker next time. And then we had 17 years of the good and the bad Alan Greenspan. Sort of like a Charles Dickens introduction, “It was the best of times, it was the worst of times.”

The IRA: Well, Anna Schwartz has called several times for Greenspan to be publicly held to account for the bad portion (Editor: The New York Times ran yet a front page article on October 9, 2008, calling for a reassessment of “a Greenspan’s legacy”). Should he be called to account perhaps before the Congress?

Kubarych: Historians should be given the opportunity to make those judgments. Those who lived through it in markets arguing with Greenspan, sometimes supporting him, but it isn’t ready yet, it’s too early to assign blame.

Whalen: Isn’t that what Cho En Lai said of the French revolution? When asked to compare his revolution with that in France, he replied that it is “too early to know” whether the French revolution had been a success, even hundreds of years after the fact.

Kubarych: It is a polite way of ducking your question.

Whalen: Well, I disagree. I love Alan Greenspan for his clarinet playing and his winning ways, yet I despise his artifices. He shows you how impressionable and ignorant the new media are because he beguiles them. He sprinkles fairy dust over their eyes and they become bemused by the idea that he knows everything. Whereas, in my view, Alan is a lousy macro economist, a poor monetary economist, and is no kind of forecaster. What he is truly is a schmoozer and most of his life he has spent schmoozing. Alan has made the most out of a career of schmoozing.

The IRA: We could say the same of you.

Kubarych: Yes, but Dick has not had the kind of power and responsibility of a Greenspan.

Whalen: Moving the machinery behind the scenes is hard work. Being out front and taking the heat requires talent, which Alan certainly has. He was always the best politician in town.

The IRA: But while there were many crises and disturbances during the Greenspan years, most notably the October 1987 market crash which began his term, none were as massive and systemic as the current crisis.

Kubarych: You had a number of continuing crises here, LTCM, Enron, etc. Why this one got out of control is the question. Why did a bunch of mortgages going bad in a declining real estate market mushroom to the point where it threatens the foundations of the western financial system? Three letters: CDO. The collateralized mortgage obligation. Securitization is getting a bad rap. The initial mortgage-backed securitization created by Salomon Brothers and people like Lewis Ranieri, Henry Kaufman and their contemporaries in the early 1980s were relatively simple, easy to understand instruments that were a win-win for the community. They made mortgages from all around the country into commodities and opened up these local housing markets to national attention and growth. Once you could securitize mortgages, you had a process that worked so well that by 1990 some 60% of mortgages were being securitized. As an asset manager, you needed to understand convexity, but that was the worst problem you had – even with the worst of the CMOs. If the deal could be reversed engineered by the Street, you could pretty reliably track the performance of these securities and validate your views against those of others.

The IRA: Precisely. The inability of the analytic community to reverse engineer and thus dynamically follow CDOs has left the Buy Side customer at the mercy of the dealers, who all ultimately abandoned these markets. We have some colleagues in the structured finance world who may have a very elegant solution to the pricing issue, by the way.

Kubarych: Ultimately I blame the mutation of the securitization industry into a toxic, damaging thing on Fannie and Freddie. These organizations lost their moral compass and began to do things in the marketplace that eventually caused them to get into such difficulties that the CEOs were removed and all sorts of new restrictions were placed on the GSEs. Wall Street said halleluiah and proceeded to dive headlong into subprime mortgages and all the rest. The banks loved it as did the Democrats on the Hill, who are always looking to make hay about affordable housing.

Whalen: More community reinvestment act extortion?

Kubarych: No, CRA is small change compared to this. The affordable housing effort was big money. And if Wall Street had simply stopped and packaged the subprime loans into a conventional pass through security, there would be no problem. It would be the world’s most boring business. But no, instead they created pools of dissimilar collateral and derivatives and then, with the full complicity of the rating agencies, sold this stuff to adolescents in the investment community, the new rich of Asia and the Middle East. And they bought big chunks of this stuff as did their banks. But the really incredible thing is that not a few of the dealers in New York themselves did not understand this paper and a couple eventually went bust because this very paper became practically worthless or close to it. They have no idea what it means when the Street cannot reverse engineer a deal.

The IRA: Agreed.

Kubarych: The other day I bumped into one of our top NY deal lawyers, a man who really understands both politics and economics. And he reminded me that it is very difficult to get the holders of the different slices of these CDOs together so that you can do anything about them. Why didn’t anybody think this through? Why didn’t the regulators think this through? Because their bosses in these federal agencies did not want them to think it through. There was no bureaucratic mileage in confronting your boss or asking questions publicly because your boss is giving testimony to the Congress or talking to the media and saying that all of these derivatives are fine and wonderful. That meant that all of the complex structured assets comprised of derivatives were off limits for researchers and regulators.

The IRA: You are correct to link the credit derivatives with complex structured assets. The academic economists who manage the Fed’s Board of Governors have long been proponents of expanded bank activity in the OTC derivatives markets and this has been tied explicitly to complex structured assets. Prior to their demise, the Sell Side firms lobbied in Washington and at the state level to enable the use of derivatives by banks and, most significant, by soft retail investors like public pensions, and state and local fiscal agencies. We discussed this at a panel at AEI last month [insert], describing how a school district in Wisconsin took horrible losses on CDOs linked to speculative borrowing, all this to fund union-mandated health care benefits. The Fed’s board in Washington under Alan Greenspan was always a strong proponent of the fallacy that OTC credit derivatives are closely related to banking and investment, instead of mere gaming instruments. These gaming instruments have caused vast losses among public sector investors, non-professional elected officials who are not really competent to make investment decisions.

Kubarych: It is easy to be glib and talk about free markets, but I also look at these situations through both the eyes of my working class father, now 90, and my mother who worked in a tie factory. My father ended up his working life with an impressive home-made equities portfolio because he was a skillful investor. One answer to the CDO problem is very simple: make the senior managers of the banks buy their own garbage. Whatever they sell to the public they must consume themselves. Pay them their bonuses in CDOs, that’ll make them more careful.

Whalen: Yes, eat your own cooking. What was it about the first derivatives that came out of Salomon Brothers or Bear Stearns that these instruments did not have to be registered with the SEC or somebody?

The IRA: Well because Alan Greenspan, Phil and Wendy Gramm, Bob Rubin and Larry Summers all worked to ensure that these instruments were not regulated and were not subject to SEC registration. Having structured assets registered solves a lot of problems, but the politics in terms of anti-regulation and pro “financial innovation” was so intense that regulation never happened. Both parties, Republican and Democratic alike, benefitted from the largess of the dealers and the hedge funds in Washington, but now both groups are decimated.

Kubarych: Unfortunately that is not how the SEC works. They are a disclosure-based organization. They are small “d” democrats, meaning that they assume we are all equally intelligent and adequately informed, so they don’t have a paternalistic Volcker approach to issues like investor protection. Volcker never wanted to get rid of things like Regulation Q. He never wanted to get rid of Glass Steagall. He wanted to keep things simple and compartmentalized in the financial markets, and hold the buyers and sellers responsible for enforcing things like suitability and know your customer.

The IRA: In America it’s called “fair dealing.” This crucial concept about the nature of economic exchange comes from the Greek concept of proportional requital as explicated in the Nicomachean Ethics of Aristotle. This is why, for example, a currency or interest rate swap fits the definition of a “fair deal,” but a credit default contract does not, being more generously a form or insurance or option. The former is an investment instrument, the latter a “barrier option” or speculative contract, although if used to hedge a real exposure it clearly has utility.

Kubarych: Yes. But the mindset that believes in investor protection and fair dealing is considered old fashioned today and outright wrong to someone like Alan Greenspan, who subscribes to a different world view than a Volcker, in my opinion. Greenspan is also a “small d” democrat and believes all people are equally capable.

Whalen: No. Alan Greenspan was raised in the apartment of his aunt because his father, a small stock broker, went broke during the Depression. And his mother had to flee to a sister’s home and later the couple broke up. Alan was raised as the product of a broken home in Washington Heights, so he knows all about the realities of life. He had lots of smart friends who were hustling to make a living and he read a lot, but he was adrift. Greenspan had an early marriage that did not work out, but then comes a tremendous infatuation, Ayn Rand. Never lose sight of the fact that until Greenspan was in his late forties, Rand was arguably his love object and the person most responsible for shaping him intellectually, from the inside out. She was invited to his swearing in for the Council of Economic Advisers under Ford. I remember Alan once asking me to come into the Ford Adsministration to help with speech writing, and my reply was simple: “The President can’t read, so what’s the point of writing?” As we all know, under Rand’s tutelage Alan came under the sway of Objectivism, which to me looks like some strange justification for selfishness. Alan has less of the protective instinct of protecting the little guy than most conservatives I have known.

The IRA: Reminds us of Tom Sowell’s book Conflict of Visions, where he compares people in public life in terms of constrained and unconstrained visions. The constraint is the micro level result of the little guy losing a job or a retirement annuity. The unconstrained view of an objectivist or a pure Darwinian is that the particular suffering of some is part of society is the necessary grease for the wheels of society. Or to consider a completely different example, when Barrack Obama said several times during the last debate that the US would violate the borders of allied nations in order to pursue Osama bin Laden and his cabal, that certainly got our attention. People with constrained vision who understand the nuances between an objective and an optimal result would prefer to see Pakistan or another Arab state catch and prosecute bin Laden of their own initiative.

Whalen: That may be, but I am talking about Greenspan the man. When you went to see him at the Fed as I did many times, it was not the same Alan that I grew up with in conservative politics.

Kubarych: Yes he was a different guy.

Whalen: Power changed him. And the Chairman, with a capital “C,” was a man who in my view saw visions, objectivist visions of supermen, who figure very prominently in Rand’s work. The superman is a recurring figure in her narratives. And Alan was the incarnation of the mystical superman who came to earth to lead us lesser figures.

Kubarych: Another way of putting it, especially since I have three children in college and at least two of them are studying the subprime crisis and related matters, is to recall my one child who is a scientist. When my political friends in the environmental movement get too confident in their views, I send them to one of the URLs from my scientist son to keep them honest. I remind them how tough are the standards of proof in science, how rigorous a process researchers must complete before even suggesting a conclusion. Real people of science have strong views, but they are conditional. I have another son who uses his skills as a journalist and forensic analyst to work very successfully at a hedge fund. So I am around a certain mix of people and understand the ways in which they gather data and reach conclusions. And Greenspan is non-empirical. He knows the numbers but he is not empirical. I don’t think Greenspan has ever read a prospectus for a CDO, but when he served on the board of one industrial company, I’m told, he was probably the only guy in the room who actually read the materials prepared for the directors!

Whalen: Exactly, Alan loves sports and things like freight care loadings. And because he knew and referred to the data, everyone assumed that he uses this data as the basis for empirically derived views and policies. He loved corrugated box data and scrap metal data, but all of these data points were used to build a tower to the sky.

Kubarych: But he had the tower in mind before he gathered the data. He already knew the conclusion that his vision indicated, thus the data points were gathered with that end in mind. The trouble with that approach is that it tends to be an unreliable forecasting procedure: sometimes it works great, sometimes not so great!

Whalen: Ha!

The IRA: So gentlemen, let’s talk about the continuing crisis and how to get out of the hole we’ve dig. In the risk management world, the first rule is that when in a hole, stopping digging. Any thoughts?

Kubarych: Well, there seem to be two Republican parties, maybe three. There’s the Republican party of Hank Paulson. And there is the Republican party of Glenn Hubbard. Here you are in the worst financial crisis in many generations, Glenn Hubbard, Hal Scott and Luigi Zingales with a totally different approach to solving the problem on the very week when we are supposed to see a compromise.

The IRA: Well, Paulson is arguably a Democrat by nature and certainly went to see the House and Senate majority leadership before consulting with the Republicans, which was clearly a bad move. Had Paulson consulting the members of his own president’s party first, he might not have cut such a comic figure.

Kubarych: I have never seen a party split so publicly. We’re not talking about the vote, we’ll get to that. But the real split in the Republican party was between Paulson and Glenn Hubbard. Why is Hubbard so revered by conservative republicans in Congress? Because he is the architect of the Bush tax cuts. That is their finest hour and he sold it. He said Paulson is wrong, Zingales’s piece is right and here’s how to go do it. He and others have been pushing the bailout program from an asset purchase approach to a recapitalization approach.

The IRA: As have we and Josh Rosner, among others. But note that we justify our call to Treasury and the Congress to recapitalize the banks not because of losses to date, realized or not, but because of the prospective perfect wave of real, old fashioned charge-offs approaching. Steve Liesman at CNBC actually got Rep. Barney Frank (D-MA) and Treasury officials several weeks ago to confirm the equity component in the mix. Indeed, Frank is said to have taken credit for including leeway for Treasury to purchase equity stakes in banks along with Rep. Spencer Baucus (R-AL).

Kubarych: Recapitalization vs. buying or guaranteeing assets is a fundamental difference. If Paulson had picked up the phone and called Glenn Hubbard, which I doubt that he did, then he would have at least started a dialog and even if he disagreed with Hubbard’s take, at least he would now understand the differences in views. (And of course the plan has been transformed into a mixed approach that actually started with recapitalization, even as the preparatory work for asset purchases through reverse auctions dragged on and on.)

The IRA: Paulson’s first instinct was to talk to the Democrats on the Hill. A very revealing decision. But the fact is that the numbers are so compelling that the recapitalization priority for the banks would have made its own case eventually. Having it in place now allows the US banking system to prepare for the next four quarters of losses and restructuring of retail and commercial exposures.

Whalen: Let me interject into this illuminating discussion one important thing, a point that applies to both Greenspan and Paulson namely regarding power. When people are elevated to a level of extreme visibility and seeming omni-competence, where they are believe to be almost god-like in their powers, they are deeply reluctant to admit that they don’t know anything. To pick up the phone and ask somebody, “what about this?”

Kubarych: And Volcker did that all the time.

Whalen: He was Paul Volcker. He knew who he was and was comfortable with colleagues like yourself and his circle of friends both sharing and acquiring knowledge. Decades ago when we had created the primer on financial crisis for Reagan, there was still an enormous amount of education required within the government and with the public. I can remember when one of the smartest people in the Reagan Administration, a very young David Stockman, called me one day and asked in hushed tones “is there anyone else on this line?” I replied “no” but worried what he was about to confess. Then he asked if I knew about something called “commercial paper.” I said: “I’ll be right over” and we met later that day to discuss the matter. I showed him the back of the Journal of Commerce with the rates for various types of commercial finance and he got it. Think of the many times when this republic of ours has been saved by a very important person having the humility to pick up the telephone and ask someone a question.

The IRA: We’ll leave it there. Thank you gentlemen.

Questions? Comments? [email protected]


Originally published at The Institutional Risk Analyst and reproduced here with the author’s permission.

2 Responses to "Fed Chairmen and Presidents: Roundtable with Roger Kubarych and Richard Whalen"

  1. Lloyd Gillespie   October 30, 2008 at 3:30 pm

    Excellent piece, Chris. So what’s next?___Poker?___Ol’ Maid Debt Economics…?

  2. Guest   November 1, 2008 at 2:58 pm

    On Deflation VS InflationI have a different opinion from our beloved professor.Short term: Deflation-like picture due to following, but no true deflation1)Decrease of housing price (due to rupture of housing bubble related to unwinding of massive securitization, but not related to decrease of housing demand)2)Decrease of equity price (due to massive sale of stocks from on-going deleveraging process related to credit crisis: by hedge funds, leveraged bonds, and other redemptions)3)Decrease of commodity price, including oil (also due to on-going deleveraging process by indiscriminate selling by those funds)4)Lack of increase of wages (due to economic contraction and less demand of service sector secondary to credit crisis: there will be minimal decrease of wages if any)5)Rise of USD dollar (due to repatriation of US dollars from around world after foreign equity selling and high debt exposure of emerging market)Early term: Reflation1)Credit expansion due to massive injection of bailout programs2)Unavoidable monetization to fill credit expansion3)Destabilization of consumer price index4)Increase of competition among companies, producers, service sector, and retailers5)Gradual increase of bankruptcy of producers, service sector and retailers6)Gradual increase of consumer goodsIntermediate term: Inflation1)Increase of equity price (due to more available credit and money and very low Fed rate)2)Increase of essential consumer goods such as foods, essential services and others (due to price increase by the remaining goods handlers and service companies due to lack of competition after bankruptcy has cleaned the many less competitive producers, service sector companies, retailers)3)Increase of commodity price (due to flight to safe heaven, such as gold and silver, and constant demand of essential goods and services: you have to eat and have service even in recession, example car repair etc. although you don’t have to buy toys and leisure activities)Long term: Hyperinflation1)Further increase of essential consumer goods and services (due to moremoney printing by Fed)2)Rapid deflation of USD dollarThis will lead to slow economy and hyperinflation