A Conversation with the former CEO of BB&T.
Question: What bank regulatory mechanisms, if any, might have prevented the crises? (Dan Indiviglio, The Atlantic Business Channel):
John Allison: In my opinion, the crisis was primarily created by government policies, specifically the Federal Reserve putting in too much money under Greenspan where we had negative real interest rates for two years. And then Bernanke inverted interest rates, which created terrible pressure on bank margins. We couldn’t have had a bubble in the economy if the Fed hadn’t printed too much money. It ended up in the housing market because of Freddie Mac and Fannie Mae, these two giant government sponsored enterprises. So it wasn’t really the regulatory structure that created the problems, it was government policy from the Fed and through Freddie Mac and Fannie Mae.
What is irony is the perception that the banking industry was de-regulated. In fact, the regulatory environment during the bubble, was the worst in my career, it was just mis-regulation, it was a huge amount of focus on—you see a huge amount of focus on the Patriot Act, and no focus really on traditional risk management. So they contributed to the crises more in an indirect way, but the real cause of the misallocations in the economic system came from the Federal Reserve and Freddie Mac and Fannie Mae.
Question: What was your experience in dealing with the Treasury’s bank bailout?: (Dan Indiviglio, The Atlantic Business Channel)
John Allison: I was very opposed to the TARP program. In fact, I wrote congress and tried very hard to keep TARP from happening. Unfortunately, however, once TARP was approved by Congress, there was significant regulatory pressure placed on all the large financial institutions to participate in TARP, particularly on all the $100 billion and over banks. The pressure was based on Bernanke’s study of the Great Depression, where Roosevelt tried to bail out individual companies and the market reacted when he did that. At the time that TARP was instituted, there were three large financial institutions that were under stress, but Bernanke didn’t want to bail those three out, because it’d be obvious he was helping them, so he used regulatory, I mean, intense regulatory pressure, to encourage all the $100 billion and over institutions to participate.
TARP was really a negative for the financial institutions, we didn’t need the capital, we had to pay very high interest rates. They got warrants. And so it was really a subsidy for the unhealthy institutions at the expense of the healthy institutions. BB&T was one of the first banks to pay back TARP, we paid it back as quickly as we possibly could.
Question: Why was TARP so costly to BB&T?
John Allison: All the large financial institutions, the $100 billion-plus institutions were basically strongly encouraged, effectively forced to participate in TARP because the Federal Reserve didn’t want the market to know the specific institutions that were being bailed out and by encouraging everybody, including the strong institutions, to participate, they obscured the fact that certain institutions were being saved. If you didn’t need the capital, the fact that you had to pay a very high interest rate and give warrants to the government was very expensive. In our case, that was several hundred million dollars, probably, and it turned out when they did the stress test, we really didn’t need the capital anyway. So I thought it was a redistribution from the healthy institutions to the unhealthy institutions and not good government policy, although they had created such a panic, they may have needed to do something, but I don’t think TARP was the answer.
Question: What do you feel will be the long-term consequences of TARP?
John Allison: I think the long-term consequences are very negative and the classic example is GMAC. GMAC is the automobile finance arm of General Motors. GMAC contributed a lot to the problem we have in the automobile business, in order to sell automobiles a number of years ago, they invented the 100 percent car loan, payable over seven years. And what that meant is most people owed more on their car than it was worth after three or four years so they can’t go buy a new car. And now, and of course, GMAC got a lot of cars back and had huge losses in that regard. And now the government keeps pouring money into GMAC, keeping them in business under the theory that there’s no financing for automobiles, which is not true. People like us are in the car business, we just aren’t going to do the dumb stuff that GMAC is doing. You can’t misallocate capital, invest in things that shouldn’t be done, and raise your standard of living in the long term, and that’s what government policy is doing. So poorly run institutions need to fail and then that capital gets reallocated to better-run institutions. That’s the way markets work. You have to have a down side. And I do think that the healthy institutions have definitely been hurt, hurt badly by keeping the unhealthy institutions in business because these unhealthy competitors are continuing to do things that drive down margins of profitability for the healthy institutions. You could see healthy institutions in trouble because of keeping the unhealthy in business.
Question: Should the US follow the lead of countries like Canada and Denmark by discouraging mortgages with less than 20% down payments? (Scott Sumner, Money Illusion)
John Allison: Well, it should be noted that the reason we had the low down payments was because of government policy. It was a very strong government policy to increase the home-ownership rate above the national market rate. That was specifically executed through Freddie Mac and Fannie Mae, who were very dominant in the affordable housing, now sub-prime market is being executed today by the FHA. So what we really need to do is get the government out of the home lending business, let home lending go back to traditional banks like it was in the savings and loan industry years ago before the industry was destroyed by hyper inflation and high interest rates and that would impose a discipline. I don’t think a government should set minimum down payments, on the other hand, they shouldn’t encourage no down payments and low down payments, which is really what they have been doing.
Question: What was responsible for BB&T’s relative success and why weren’t other banks so fortunate?
John Allison: Well, BB&T certainly, we’ve had our challenges and we always have made mistakes, but we have done much better than other financial institutions and I primarily think it’s because of the value system we have at BB&T. We’ve had some good strategies and good execution, but they are very secondary to the fact that we were very much a principal driven organization. We’ve had a very strong culture around ethics and values for a long period of time and we’ve reinforced that over and over again. And that value system is based on rationality, which demands honesty, demands integrity, demands a long-term perspective on your business. And it’s caused us to do some things like refusing to make loans where eminent domain was used to take property from one individual to another individual.
Interestingly enough, our value system kept us from making the negative amortization or what are the pick-a-payment mortgages. I remember pick-a-payment mortgages where somebody buys a house and their interest is $1,000 a month, but they only pay $500 a month. We chose not to do those kind of mortgages, not over some grand insight, because at the time, you could sell them in the secondary market, but because one of the fundamental commitments in our mission is to help our clients achieve economic success and financial security. We expect to make a profit doing it, but we don’t consciously want to ever do anything that’s bad for our clients. We knew real estate markets wouldn’t appreciate a 10% a year forever, we didn’t except them to depreciate like they had, but we knew that people would be taking an inordinate risk with those pick-a-payment mortgages and we chose not to do them over ethics, not over economics. So BB&T’s strength, I believe, has been its value system.
Question: What role did lax mortgage regulation have in the crisis?
John Allison: I think lax regulation played very little rule, I think it was incentive, the government was trying to raise the home-ownership rate above the national market rate. It was a stated objective of the Clinton administration, a stated objective of the Bush administration, they were pushing affordable housing, i.e.: sub-prime lending. It was a government policy. So it wasn’t just the, it wasn’t a lax regulation, it was a goal to make more risky home mortgages, they thought it was a good thing. So it’s ironic that a lot of the same people now that are criticizing the industry, like Barney Frank and Chris Dodd were the people that were most supportive of affordable housing programs. Yes, market participants made mistakes, but in the context of a government stated goal of raising home-ownership above the national market rate, i.e.: a goal supporting sub-prime lending.
Question: Would a triage solution, where healthy banks were left alone and unhealthy ones put through FDIC resolutions, have better managed the bailout? (Arnold Kling, EconLog)
John Allison: I definitely think it would’ve been feasible and I definitely think it’d have been better off in the long term. It’s difficult to argue about whether we’d have been better off in the short term, I think that’s a complicated question. But in the long term, it’d be much better off. In my career, Citigroup has failed three times, been bailed out by the government three times, and every time, they’ve gotten bigger and worse. There is a tremendous moral hazard to the government constantly keeping poor run institutions in business and it prevents a natural market correction process. So we shouldn’t have been in the situation if we hadn’t had the Fed over spending the money supply and what happened with affordable housing through government policy, we wouldn’t have been in the shape we were in. But given the situation, a triage solution would have really been a better solution.
Question: How much higher should the capital ratios of big banks be relative to small banks? (Felix Salmon, Reuters Finance)
John Allison: I don’t think the capital ratios of big banks should be higher than small banks. In fact, my experience is exactly the opposite, the small banks are the ones that tend to be the most under capitalized and particularly start-up small banks. But I think everybody’s capital ratios ought to be higher. I think that government policy has encouraged banks to have lower capital than they should. One of my cures, long term, for the industry, it’s not my optimal cure, but it’s a more practical cure, would be to set a goal for banks to have 20, 25% equity, give them a long term time to do that and shift the risk from the taxpayers back to the shareholders of the bank. It would also answer the two big, the failed question in that either Citicorp could raise that kind of capital or not, and if they couldn’t, then they would have to shrink. Now, it’s very important that be combined with several things. One, we need to reduce the FDIC insurance back to the $100,000 level to take out that risk. Secondly, we need to make it explicitly clear the Federal Reserve can’t bail out General Electric or non-banks because banks have to have a special proxy if they have to have a higher capital levels and it should be against the last for General Electric to be bailed out by the Federal Reserve.
And finally, you have to eliminate about 90 or 95 percent of the regulations that impact the industry because the industry can’t afford to have higher capital levels and a huge regulatory burden. So we ought to shift the risks back to shareholders, 20-25% of pure capital for all banks in a long-term systematic fashion, but coordinated with substantiated reduced regulation, so the industry can be competitive and healthy.
Question: Should money center banks be broken up? (Robert Lenzer, Forbes)
John Allison: Well, my general posture is that I am opposed to any trust. On the other hand, if the government has determined some institutions are too big to fail, then they have to be broken up because it creates huge market distortions, particularly in the good times. Because anybody that has an implicit government guarantee can afford to take dramatically more risk. So what’s going to happen, if we don’t break up the institutions that are too big to fail, then on the next cycle, when the good times comes, they’ll come, they’ll be taking enormous risk and then the next cycle will be a really, a disaster. I personally don’t believe they’re too big to fail. I think they should be allowed to fail and there ought to be a process where they fail just like any other company and then you wouldn’t have to break them up. The capital requirement that I described in the last, answer to the last question, really would help deal very effectively with this issue.
Question: As a board member who has perhaps been involved in setting pay levels for executives, what is your view of executive compensation? (Mark Thoma, Economist’s View)
John Allison: I think executive compensation ought to be set by the marketplace. Boards do make mistakes sometimes in the executive compensation process. I think there have been some obvious abuses of executive compensation in a few cases, but I think the more generic problem is not that people could be paid well, but the measurement of performance is not right. And I think the two errors that have been made, one, a lot of time performance is measured too linearly, it doesn’t include the comprehensive performance, and secondly, a lot of times performance is too short term. So I think that boards should be setting compensation, I think highly performing people ought to be paid very well based on market conditions, but I think boards should do a good job and I think, frankly, I think our board has done a good job being sure the compensation is not just linear and being sure it covers a long period of time, not just what happens over a short period.
Question: Is giving shareholders more control over the level of compensation that executives receive an answer to the problem?
John Allison: I think that the shareholders have to select the board members and the board members have to make those kind of operating decisions. I don’t think shareholders have enough information to make concrete operating decisions. They can put the board in the position--they simply couldn’t attract the kind of talent that they need to operate. We’re seeing that right now with some of the interference by the government in setting executive compensation. I do think shareholders should be very careful in selecting the board members. I would say this though; I don’t think shareholders have been un-guilty, particularly institutional shareholders, in what’s been going on recently, because a lot of shareholders are very short term oriented. And so they encourage short-term performance and they give executives that act in a short-term manner. So I think if shareholders want a different long-term result, then they need to invest for the longer-term perspective and that’s a really important responsibility versus micro managing the board process.
Question: What measures should we take to help prevent crises in the future?
John Allison: Well, if I were in charge, I would go to a private banking system in a monetary standard based on market criteria, which would probably be a gold standard. Not because there’s anything magical about gold, but because gold is limited, it’s hard to find, it’s expensive, and it provides discipline. As long as we have a Federal Reserve, we’re going to have a high level of government debt until we get into serious financial trouble—it’s almost inevitable. If you look, governments have been basing the currency since at least the Roman Empire, and even before that, and we have been debasing our currency and we will get in trouble. If we don’t go to a gold standard and a private banking system, then I think the Federal Reserve ought to have less power, not more. We ought to go with what Milton Freedman said and grow the money supply at a fixed rate, like 3 percent. Because every time they over correct, you don’t know that the over correction has happened until two, three years down the road and we’re looking at that same kind of risk right now with stagflation in the future.
And then the other option would be the one I described before with more capital and less regulation, which is a very practical option and almost the opposite of the direction we’re going now with just plain more regulation, we’re going to make the system more vulnerable, not less vulnerable.
Question: Can you elaborate on your criticisms of government policies and explain what you see as the most promising alternatives to these policies?
John Allison: Yes. I think that the primary cause of the financial crises was government policy. We don’t live in a free market in the U.S. we live in a mixed economy. The mixture depends a lot on the industry. Technology is probably 80 percent free, 20 percent government, financial services is 70 percent government, 30 percent free. Not surprising, the most regulated industry is the one that had the biggest problems. What happened is government policy created a bubble in the residential real estate markets, that bubble burst, which bubbles always do, and that got transmitted into the capital markets and into the economy in general. It is true that individual financial institutions made some really big mistakes, but it was in context of government policy errors. And the three big causes were first, the Federal Reserve. In a certain sense, people don’t, they know this, but they don’t get it. The government owns the monetary system in the US. In 1913, the monetary system was nationalized. If you’re having trouble in the monetary system, by definition, it’s a problem of government policy. If interstate highway bridges were falling down, people would say, “Well, what’s wrong with the government? They own the highways, they own the monetary system.” The Fed was created to take out volatility in the economy, what they’ve done is take out the short-term volatility and push problems into the future. Because in a free market, as human beings, we’re not…we’re always, it’s always in a correction process, good businesses are growing, bad businesses are going out of businesses. If you take out the bottom side, you push the problems into the future.
And then specifically, Alan Greenspan had negative real interest rates for several years, Bernanke created inverted yield curve. Those are huge incentives for people to invest and take high levels of risk. We couldn’t have had a financial crises if the federal reserve hadn’t printed the money. The FDIC creates a lack of market discipline, where people like **** West and Indie MAC, that all, and Countrywide, all that fail that can grow their assets, high risk assets, very easily by buying deposits and because of the FDIC insurance, the typical depositor doesn’t think about the risk in the institution they’re invested in. And then it ended up in the housing market because of a goal really set in 1999 by Bill Clinton, for Freddie Mac and Fannie Mae to have over half their loan portfolio in affordable housing. And so a lot of the bubble ended up in the housing market and Freddie Mac and Fannie Mae never would have existed in a free market. They were guaranteed by the federal government, when they went broke, they were leveraged a 1,000 to 1 and they had $5 trillion in liabilities. And politics played a huge role. I personally was involved in the committee trying to do something about Freddie Mac and Fannie Mae, because you could run the numbers and you knew they were going broke, but Congress wouldn’t do anything about it, because affordable housing was kind of a religious belief of Congress and secondly, **** were huge contributors to both democratic parties. So yes, individual financial institutions made mistakes, but in the context of some really serious government policy errors.
Question: Do you agree with those that recommend eliminating deposit insurance?
John Allison: I totally agree and I think getting rid of deposit insurance would be wonderful. In fact, 10, 15 years ago, the financial services roundtable actually went through an exercise looking at a cross guarantee program among the large financial institutions. I believe that if we put that program in place, similar to what happens with the insurance industry, what the brokerage industry has, we would never have had, even with the Federal Reserve, even with Freddie Mac and Fannie Mae, we certainly wouldn’t have had a misallocation of the magnitude we had. Deposit insurance played a huge role in the big failures, in the Golden West, in the Countrywides, in Washington Mutual, etc., etc. And the reason for that is the FDIC, this is my experience of that career, in good times, they don’t really impose any kind of discipline, and then in bad times they overreact. Right now, the FDIC is tightening like crazy, making it much harder to make loans. Now, they say they want you to make loans, but they really don’t, because the local examiner, all he can do, all that can happen to him is his bank can get in trouble.
So the FDIC and the federal examiners are tightening bank standards now, after the horse is out of the barn. In the good times, they weren’t really paying any attention. We’ve taken over some failed institutions and it was obvious in these cases that these people were making bad loans, good examiners would’ve shown that, but they don’t act until after the fact. If we had a co-insurance pool, where the banks really were taking the risk, we would be far more disciplined to make sure the companies that were in our co-insurance pool had enough capital and had the proper kind of risk standards. So I’d vote to get rid of FDIC insurance, not that we don’t need it, we need some kind of insurance, but I think it ought to be an industry-based, industry-controlled pool where we would have a huge motivation to discipline all the participants in the pool.
Question: In what ways did the market fail?
John Allison: I don’t think the market per se failed. I think that government policies create market distortions, i.e.: too much money with the Federal Reserve, the allocation to housing. There was one factor that created an odd market failure and that was fair value accounting. Fair value accounting is supposed to be a good thing because it’s marked to market, but in a panic situation, the market is not functioning, it’s not a market failure, it’s just a nature of panics. And that created distortions. And I’ll give you a simple way that that happened. Let’s say there was a mortgage bond in the market that had originally been $100 million, but because of mortgages not being paid under the bond and people that weren’t expected to pay in the future, economically that mortgage was worth $80 million, and that’s what it should’ve sold for. But because of the panic, the only buyers were deep discounters that would only pay $50 million for it. Now, that had big implications because under this fair value accounting, the financial institution, instead of marking the mortgage bond down $20 million, had to mark it down $50 million. Financial institutions, banks, or leverage, we’ll just use an easy number, 10 to 1. So instead of destroying $200 million worth of lending capacity, which the loss of $20 million in capital would do, it destroyed $500 million in lending capacity, i.e.: 50 times 10 instead of 20 times 10, because of the accounting system. But here’s why the market didn’t work. It was why didn’t the market correct that? Well, there were people like BB&T that have plenty of money, we saw that bond was worth $80 million, we could buy it for 50, if we went in and started buying and everybody else like us had money started buying, then the price would’ve gotten certainly close up to the $80 million. But we wouldn’t buy because we couldn’t take the accounting risk. Because even though we knew bond was worth $80 million, we weren’t going to buy it even for $50 million, because we didn’t know that next quarter, under this panicky market, it would only be, a fair market value quote would only be $40 million because everybody would be scared and we’d have to take a markdown. So fair value accounting created a market distortion that never would’ve existed in a free market. I would just point out that the SEC makes the accounting rules and yes, we do not have a private based accounting system, I don’t know any big firm that runs their internal operations based on GAP accounting, I don’t know of any hedge fund that runs their operations based on GAP accounting and so the SEC, ironically, through the control of the accounting system, created a market distortion that I do not believe would’ve existed in a pure, free market.
Question: Is there any reason to believe that government intervention outperforms markets in the long run?
John Allison: I don’t believe so. I mean, I think that government intervention in the long term almost always creates poor economic allocation processes. You can make some arguments in the middle of a panic that government interference helps you in the short term, but the long-term price for government interference is very high. Let’s face it, you know, there are some really significant, long term economic challenges, however we feel, you know, I think the economy is in some kind of recovery, I think our most likely intermediate scenario is kind of a stagflation environment, but I’m really worried about the US 20 and 25 years down the road. We got huge deficits in Social Security, huge deficits in Medicare, we got trillion dollar plus operating deficits, a dysfunctional foreign policy, we got a big problem with the demographics with the retiring baby boomers, we got a failed K-12 education system. You can paint a very scary picture 25 years down the road if we don’t provide the discipline that’s necessary. And what that means is not more government regulation, but a return to what made America great in the first place, individual rights, free markets, entrepreneurship, increases in productivity. You can’t print your way out of problems, if you could, Zimbabwe would be doing great, right? If somebody gave me a trillion dollars, Zimbabwe, whatever it is, Bill the other day, said it was worth 5 cents. You have to produce your way and we need to create the kind of an environment where productive people are encouraged to take rational risks and grow their businesses and we haven’t been doing that, so that’s our real problem, not market failure.
Question: What will the long run implications of government’s involvement in the financial sector be?
John Allison: I think the long-term implications are very detrimental. If you want to really think about what happened in the housing crises, it was a government policy, through Freddie Mac and Fannie Mae and affordable housing policies, what they call the community reinvestment act, etc., that created a massive misallocation of credit. If the government gets into allocating credit over time it will make sure we aren’t as productive as we should be. So the government regulations usually in the end look like credit allocations usually to those that are politically favored at the expense of making sure credit is allocated to the most productive segments in the economy. So I think government regulation in the long term is almost always destructive.
Recorded on: December 10, 2009