Vern McKinley: Financing Failure – Panic and Lessons Learned … or Not
By Anthony Wile - May 24, 2015

Introduction: Vern P. McKinley is a Visiting Scholar at George Washington University Law School, a Research Fellow at the Independent Institute and author of the 2012 Institute book, Financing Failure: A Century of Bailouts. From 1985 to 1999 Mr. McKinley worked with the Board of Governors of the Federal Reserve, Federal Deposit Insurance Corporation, Resolution Trust Corporation and Department of the Treasury's Office of Thrift Supervision. In 1995, McKinley graduated with honors from George Washington University School of Law. Since 1999, McKinley has served as a legal advisor and regulatory policy expert for governments on financial sector issues in the U.S., China, Nigeria, Indonesia, Ukraine, Kazakhstan, Latvia, the Philippines, Yugoslavia (now Montenegro), Kenya, Morocco, Sudan, Libya, Afghanistan, Armenia, Kosovo and Tajikistan. McKinley has completed policy work for both the American Enterprise Institute and the Cato Institute and has served as an Alumni Council member of The Fund for American Studies.

Anthony Wile: Thanks for making time to speak with us. You gained valuable firsthand experience on the internal workings of Washington through your years of work as a legal advisor and regulatory policy expert and have extended your reach past US borders to advise numerous governments on financial sector issues. Compared to the vast majority of financial experts, your viewpoint is truly global. Looking globally, what level of commitment would you say the world's governments have today towards returning to fiscal responsibility?

Vern McKinley: I would say specifically as it relates to my research on the fiscal expenditures for bailouts that right now there is a great deal of strong rhetoric and toughness demonstrated regarding not bailing out institutions that approach failure at some unspecified point in the future. But based on the history, when the next crisis comes around, those in key positions like the Federal Reserve Chairman and president of the New York Fed, treasury secretary, chairman of the FDIC, will panic, tell their Chicken Little stories about what bad things will happen and bail out the banks just like they did in the 1980s and the 2000s.

Take the example of FDIC Chairman Bair. She talks tough now about bailouts, including while promoting her book about the crisis a few years ago, but when she was chairman of the FDIC she led her board in voting for bailout after bailout: Wachovia, Citigroup, Bank of America, the FDIC Debt Guarantee program.

Anthony Wile: Are there any notable examples of countries that are leading or, conversely, lagging in this pursuit? What's working, or not?

Vern McKinley: Two examples I am aware of for countries that have been willing to cram losses down on creditors through 'bail in' have been Kazakhstan and Cyprus. Both countries imposed losses on creditors who, for the most part, were foreign creditors, so I think the lesson is that it is easier to follow through on the tough talk when foreign creditors are going to take the hit as opposed to domestic creditors.

Otherwise, because there have not been many failures or near failures since about 2010, no one has had to follow through on the tough rhetoric. Meanwhile in the US, we have Fannie Mae and Freddie Mac as a remnant of the crisis and taken over by the government in 2008. No one seems to have the political will to come to a final conclusion on what to do with these massive, undercapitalized behemoths that have lingered under government control for the past six and a half years. To me, these two are a good indicator of how the authorities in the US are likely to respond to a "too big to fail" institution at some time in the future.

Anthony Wile: In your 2012 book, Financing Failure: A Century of Bailouts, you examine the financial crises of the 1930s, 1980s and 2000s and disprove claims of regulators and politicians that the bailouts during the most recent crisis were a necessity for avoiding a Great Depression. That's not an easy task given that government agencies seem to consistently withhold the truth of their policies and interventions from the public. Can you summarize the case you've made that the bailouts were anything but necessary?

Vern McKinley: The claims of the Federal Reserve, FDIC and Treasury regarding the bad things that would happen if the large institutions were allowed to fail were wildly overstated. In my book, I went through the available documentation at the time and there never was any clear underlying evidence presented of what is called contagion or the domino effect, which means if you let one fail they all start to topple. It was all just wild speculation about what might happen to justify extending the bailouts, but there was never any detailed proof that if, for example, Bear Stearns was allowed to fail that all the other various dominoes were lined up to fail, too. If you ever get into a discussion with someone about whether the bailout of Bear Stearns was justified, simply ask them which institutions would have failed if Bear Stearns failed outright as opposed to the bailout which happened. I can guarantee that silence or a whopping rationalization will be the response.

Anthony Wile: Your findings for Financing Failure are based on information about the bailouts released as a result of four Freedom of Information suits you brought against the Federal Deposit Insurance Corporation, the Board of Governors of the Federal Reserve and the Federal Housing Finance Agency. Tell us about that process and what led you to file those suits.

Vern McKinley: Like everyone else, as the fall of 2008 unfolded I looked on in horror at the panic being displayed by the financial agencies. I started pulling together some of my thoughts to publish an analysis on the bailouts. As part of that I submitted a few standard FOIA requests for information. The Federal Reserve in Washington largely ignored me and the FDIC gave me documents, but they were so heavily redacted that they were incomprehensible. I knew I was on to something when they were so opaque in answering some basic questions about why they did what they did. Eventually, I did get some useful documents after fighting the agencies in court for a few years and that led me to the conclusion that the underlying analysis for the bailouts was just seat-of-the-pants and ad hoc.

Anthony Wile: According to , "Enacted on July 4, 1966, and taking effect one year later, the Freedom of Information Act (FOIA) provides that any person has a right, enforceable in court, to obtain access to federal agency records, except to the extent that such records (or portions of them) are protected from public disclosure by one of nine exemptions or by one of three special law enforcement record exclusions. A FOIA request can be made for any agency record." Were none of the agencies you contacted prior to the suits forthcoming with information? Were there other agencies you contacted?

Vern McKinley: None of the agencies involved in the bailouts could be described as forthcoming. Each in their own little way was evasive, but in subtly different ways. My experience was that the only way to get their attention was through the courts, so that is what I did with the help of Judicial Watch. It is also what I plan to do going forward any time I hit a brick wall with the agencies in getting documents.

I spoke about my book in front of one group made up largely of people in the defense and intelligence community. They were appalled at the fact that these agencies would withhold this detail, as compared to more justifiable reasons that documents are traditionally withheld, for example due to national security reasons.

Anthony Wile: What reason(s) did they provide when refusing to publicly disclose policy information on the bailouts?

Vern McKinley: There is an exemption under FOIA called deliberative process. This is a huge exemption that the agencies invoke all the time. Essentially, if they have their internal discussions about policy justifications for an action they can shield those discussions under the deliberative process exemption. Supposedly, they want to be free to make decisions without someone looking over their shoulder and scrutinizing them. We took this issue through the district and appeals court and ultimately petitioned the Supreme Court to limit this massive loophole for the agencies, but the courts generally give deference to the agencies on these matters and the Supreme Court was no different.

Anthony Wile: Did the lawsuits result in release of the information you were looking for?

Vern McKinley: In my book, I do a side-by-side comparison of one of the documents I fought with the FDIC over and eventually they disclosed it to me after the Wall Street Journal editorialized on my efforts. The originally released document was mostly whited out. Ultimately I received the full document without redactions. If you compare the two documents you can tell why they did not want to disclose the details. The underlying analysis was incredibly weak, embarrassingly so.

Anthony Wile: Based on your experience, do you have any advice regarding filing FOIA requests for those who are seeking other information from agencies?

Vern McKinley: If you have the time, fight the agencies yourself or get a public interest group, like I did with Judicial Watch, to help you. You will, of course, have to convince a public interest group that the documents you are seeking are worth their efforts.

Anthony Wile: Back to the meat of your book, what key differences and similarities did your research reveal between the crises in the 1930s, 1980s and 2000s?

Vern McKinley: There are a lot of similar patterns between the crises. Probably the best way to describe it is to compare it to the "stages of grief" and think through the bailouts whether it is Fannie and Freddie, Citigroup, Bear, or AIG. Stage #1 is denial from the primary regulator of the institution: "Well these institutions aren't in trouble. We supervise them. They are having some problems, but they will get through it." Stage #2 is when they are forced to realize the institution is in trouble and they panic without any real underlying basis and draw from Chicken Little's script: "If we don't save this institution the world will come to an end."

Stage #3 is the bailout: "We don't want to bail out this institution, but we have to! After all, we have to do SOMETHING!" Stage #4 is the declaration of victory: "Everything that went right with these bailouts, that was because of us. Everything that went wrong with these bailouts, that was [xxxxxx's] fault."

Finally, stage #5 is financial reform, which usually assures that we will be back in a few years bailing out institutions again: "We are done with bailouts. Never again." If you need more precise details on the repeating patterns please see Chapter 11 of my book: "The Assessment of the History."

Anthony Wile: Regarding the 2008 crisis, you question how Federal Reserve Chairman Ben Bernanke and Treasury Secretary Hank Paulson – who we all recall was the former CEO of Goldman Sachs – so easily convinced the leaders of Congress and of the congressional banking committees that unless extraordinary action was taken immediately, the global banking system would soon collapse. How were they able to do this?

Vern McKinley: Instilling panic. This is the strangest part of all the responses to the bailout. Whether it was Bernanke, Paulson, Geithner or (to a lesser extent) Bair, they tried to stabilize the financial system by telling everyone how inherently unstable the financial system was. When they should have been instilling rationality at the height of the problems in September 2008, they instead had the president go on national television to further instill fear. No wonder everyone panicked. As a senior Treasury official, Neel Kashkari, put it, the strategy to get bailout legislation passed up on Capitol Hill was, "We've got to scare the shit out of the staff."

Anthony Wile: Was there ever a real financial stability issue – a genuine threat – that left us at risk of a worldwide bank run?

Vern McKinley: There was a reason once it was clear that the bailouts were absolutely inconsistent with one another and that the crew of financial regulators calling for the bailouts had absolutely no clue what they were doing.

Anthony Wile: What was the reality of the situation?

Vern McKinley: Sure, things would have been bad if a lot of the big institutions failed. But they approach failure because they are badly managed and like any other badly managed business the appropriate punishment is to put them out of business.

I like to compare the response during 2008 and 2009 to what was done in Texas during the 1980s. If you look at the top ten bank groups in Texas in 1980 to what they were in 1990, nine out of the ten were gone. As I recall, seven failed outright and the other two were taken over by out-of-state banking groups.

What has happened in Texas in the 25 years since then? The Texas economy has been the strongest large state economy by far, all because they went through all the bankruptcies and the depths of the deep recession and let home prices plunge back to a market level. They let the market work. Paulson, Geithner, Bernanke and Bair were oblivious to this lesson.

Anthony Wile: You wrote a policy examination for CATO titled "Run, Run, Run: Was the Financial Crisis Panic over Bank Runs Justified?" Give us a summary overview of your key findings in that report.

Vern McKinley: Bank runs have had a bad rap ever since the Depression and the scene in "It's a Wonderful Life" made that reputation worse. We had a number of serious runs at the big commercial banks and savings associations during 2007 and 2008 and I went through them in the policy analysis: Countrywide, IndyMac, Washington Mutual, Wachovia and Citibank. Sure these, institutions lost access to funding, but there was no problem with the system as a whole. The agencies panicked and warned that the money was running out of these institutions and the whole system would soon collapse.

The reality is that the money ran from these poorly managed institutions to better managed institutions like JPMorgan Chase. Jamie Dimon has publicly said as much. If you look at the data on deposits during this time there was no run-off of deposits out of the system, but only steady growth through the entire period from 2007 on.

Anthony Wile: In 2007-08, at the start of the crisis, the Federal Reserve handled the bank runs that occurred with Countrywide, IndyMac and Washington Mutual responsibly – the institutions were closed quickly and not bailed out. What precipitated the policy change regarding bailouts further into the crisis?

Vern McKinley: Again, panic. Because the foursome of financial supervisors did not recognize the runs for what they were, they panicked and after late September they just bailed out all the large banks and only let the small ones fail.

Anthony Wile: How should central banks and other government entities handle a crisis?

Vern McKinley: Ease poorly managed banks, big, medium or small, out of the system. Provide liquidity to the solvent institutions with well secured borrowings, but let everyone else fail.

Anthony Wile: Should any of the bailouts have occurred?

Vern McKinley: I am not convinced based on my experience and my research that any of them were necessary. Of the bailed-out institutions, the one with the most severe systemic impact if it would have gone into receivership (a form of bankruptcy) would have been Fannie Mae and Freddie Mac. That was because they were essentially a government-granted duopoly. I brought suit against their regulator/conservator, the Federal Housing Finance Agency to find out why they were bailed out and placed into conservatorship instead of liquidated through receivership. They fought me through the courts and never did give up much information on why they made that choice. Again, as a result we have these two undercapitalized mega-institutions that will be on the brink again if we have another downturn.

Anthony Wile: Some would argue a government's responsibility is to bolster financial stability and yet during the 2008 crisis, various government spokesmen also made numerous claims about how unstable the system is. You've worked advising governments in countries that have genuine instability issues like Afghanistan, Sudan and some former Soviet republics. How did the US financial stability in 2008 compare to your experience in these countries?

Vern McKinley: I had to laugh at the statements especially by Fed Chairman Bernanke. He gave some lectures at George Washington University where he said, "failure of AIG, in our estimation, would have been basically the end." Absolutely no evidence has been presented that we were on the brink of disaster. Our system could have handled it. The problem is that during the next crisis the same expectations are going to build up and whoever is in charge at that time will likely panic just the same as Bernanke, Paulson, Geithner and Bair did. They have made the system more fragile. What we want is an anti-fragile system.

Anthony Wile: Explain the CAMEL ratings, please.

Vern McKinley: It is a 'report card type' grade that is given to commercial banks by their regulator, either the Office of the Comptroller, the Fed, the FDIC or their state authority. Banks are rated from "1" (best) to "5" (worst). If an institution is "4" or "5" it is what is called a problem bank and is in danger of failing and if it is not turned around immediately should be shut down.

Anthony Wile: Regarding the CAMEL ratings, it seems the regulator's approach during the 2008 crisis was to not admit when a bank was a problem bank or an undercapitalized bank – as if not admitting it would mean that it is not. You've mentioned that during the 2008 crisis John Dugan, the Comptroller – head of the agency that is the primary regulator of national banks – claimed that due to weakness in the financial system it had to be controlled, yet he never lowered the ratings on the "too big to fail" banks. How is this contradiction explained?

Vern McKinley: Correct. The best example of this is Citibank. They received TARP funds in October 2008, another bailout in November 2008 when they were on the brink of collapse and yet another one in early 2009. Unbelievably, they avoided being labeled a problem bank throughout this whole period because the agencies did not want to be seen as bailing out problem banks. The thought process was, well, they are in trouble, yes, but we are going to bail them out and as a result they won't be a problem so let's not call them a problem bank. Quite a feat of mental gymnastics. The reality is that Citi was a problem bank, it was poorly managed, it was on the brink of collapse and it should have been placed into FDIC receivership in November 2008.

Anthony Wile: Dodd-Frank says that lending cannot occur to an insolvent institution. Will Dodd-Frank limitations help in limiting bailouts in the future?

Vern McKinley: Dodd-Frank was not passed until after all the major bailouts. But I have no doubt that next time around, as in the case of Citibank, no matter how bad a condition they are in, the financial agencies will convince themselves that an institution is solvent and it is thus eligible to receive government funding. Maybe they will rationalize it in that giving them a bailout will make them solvent, so we can just call them solvent now.

Anthony Wile: There was a lot of talk about non-bank institutions and the risk of a bank run. In your CATO policy analysis you mention that with insurance companies like AIG, there are no individual depositors and as such they cannot be susceptible to runs. What about Bear Sterns and Lehman? What was the real concern?

Vern McKinley: Then-New York Fed President Geithner wanted Bear Stearns to appear to be bank-like in order to give them a bank-style bailout because prior to that only banks received government bailouts. But there really was no justification to bail out Bear Stearns out. As Chairman Bair said in her book, "investment banks fail." Lehman was allowed to fail, which was the right call.

Anthony Wile: Why was Lehman allowed to fail while others were not?

Vern McKinley: Your question assumes some type of inherent logic and consistency regarding the various bailouts. That would be a false assumption, as all of the bailouts were of the 'seat-of-the pants' variety. The rationalization that the Federal Reserve could not under law do anything, which is what has been offered by Chairman Bernanke, is not credible.

My sense based on the emails and other documents I was able to get a hold of is that there was a fear of the moral hazard implications of bailing everyone out, so they randomly decided allowing Lehman to fail would be a step to do address that. But any positive steps to combat moral hazard inherent in allowing Lehman to fail were completely negated a few days later when AIG was bailed out and in the weeks and months that followed when other institutions were bailed out.

Anthony Wile: Of the institutions that did experience a bank run in 2007-2008, what did depositors do with their money?

Vern McKinley: As best I can tell they simply moved it to stronger, better managed institutions. Again, the market worked.

Anthony Wile: Were these runs actually negative, or positive? Does that answer differ looking at the short term vs. long term?

Vern McKinley: If you are working for a poorly run institution like Citibank, it is negative, but for the system in the long run, it makes sense for funds to flee a poorly managed bank and migrate to a better managed institution.

Anthony Wile: America has clearly not been "saved." Where do we stand today?

Vern McKinley: Fannie and Freddie's capital is heading toward zero. Big institutions like Citibank and Bank of America are floundering around trying to get a new business model, only so they can survive until the next crisis puts them on the brink again. The financial agencies are talking tough, because they know that when the next crisis hits, they will probably be retired and not have to make the tough decisions that are called for during a crisis.

Anthony Wile: From crisis to crisis, history has repeated itself. Without meaningful policy change, what can we expect from Washington if another economic catastrophe occurs? What would meaningful policy change look like?

Vern McKinley: See the stages I mentioned above; that will be the scorecard. Meaningful policy change would be to put people in these positions at the Fed, FDIC and Treasury who know the history and know that the proper response is to shutter these large institutions when they are on the brink next time. No excuses.

Anthony Wile: In the face of crisis, the Federal Reserve can function as the lender of last resort. After the 2008 crisis, has it been determined what constitutes a bailout? Is there a time that is appropriate for the Fed to step in and, if so, what form does that assistance take?

Vern McKinley: Again, liquidity funding to solvent, well run institutions. The rest go to the undertaker.

Anthony Wile: Where can readers keep up with you – websites, upcoming events, publications?

Vern McKinley: I am working out of George Washington University Law School doing some research this year for a second book. But the easiest place to find me is on Twitter, @VernMcKinley. I post articles that I find interesting on these issues and I follow a small group of about 100 on Twitter. I have found this is a good way to keep current on all issues bailout-related. Much of my previous work is at The Independent Institute.

Anthony Wile: Thank you again for sharing your time and insights.