BRIEFING BOOK

Data Information Knowledge WISDOM

SHEILA BAIR

Location: Forbes, New York, New York

About Sheila Bair .............................................................................. Debriefing Bair …………………………………………………………..

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Bair in Forbes

"The Need For Failure,” 05/27/09........................................... "Short-Sellers Set For Flame Forum," 05/27/09……………… “For Most Banks, Not Too Stressful," 05/07/09………………. "A Captive FDIC," 04/15/09......................................................

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The Bair Interview ………………………………………………… 16

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ABOUT SHEILA BAIR Intelligent Investing with Steve Forbes

Sheila Bair is the nineteenth chairman of the Federal Deposit Insurance Corporation. She will hold that role for five years until July 2013. As the FDIC chairman, she has added programs to the agency including ones that provide temporary liquidity guarantees, increases in deposit insurance limits and systematic loan modifications to troubled borrowers. Before becoming FDIC chairman, Bair was the dean’s professor of financial regulatory policy for the Isenberg School of Management at the University of Massachusetts – Amherst from 2002 to 2006. While she was there, she served on the FDIC’s advisory committee on banking policy. Bair has also served as assistant secretary for financial institutions at the U.S. Department of Treasury, senior vice president for government relations at the New York Stock Exchange, a commission and acting chairman of the Commodity Futures Trading Commission and research director, deputy counsel and counsel to then Senate Majority Leader Robert Dole. Since becoming FDIC chairman, she has been named top Time Magazine’s “Time 100” most influential people list in 2009; she has also been awarded the John F. Kennedy Profile in Courage Award and the Hubert H. Humphrey Civil Rights award. In 2008, Bair topped the Wall Street Journal’s annual 50 “Women to Watch List”; that same year she was named the second most powerful woman in the world after Germany’s Chancellor Angela Merkel by Forbes magazine. Bair received her bachelor’s degree from Kansas University and a J.D. from Kansas University School of Law. She is married to Scott P. Cooper and has two children.

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DEBRIEFING SHEILA BAIR Intelligent Investing with Steve Forbes

Forbes: What is the greatest financial lesson you’ve ever learned?

Sheila Bair: My 87-year-old mother is a classic "buy and hold" investor who would make Warren Buffett proud. Her investment returns always exceeded those of my father, to his eternal consternation. He actively traded his stocks and got decent returns ... but nothing like the returns my mother got by simply buying stocks of companies she understood and liked, and then holding onto them.

This is also a lesson we've learn watching the financial sector. Too many financial institutions took risks they did not understand for short-term profit. So I'm a strong advocate of the "basics" and prudence when it comes to money. When the economy gets healthy again, I hope for a new "back-to-basics society." A new "old world" where banks and other lenders promote real growth and long-term value, where your generation rediscovers the peace of mind of financial security that comes from: thinking before spending, cutting up the credit cards, and maybe even living at home for a year to save some money to pay off student loans.

You’ve opposed the Obama administration’s idea for one over-arching finance regulator. Why, and what do you propose in its place?

It's now obvious that just being bigger isn't necessarily better. I don't mean to imply that there are no well-managed big banks. But when you have a handful of giants, with global reach, and a single regulator ... you're making a huge bet that a few banks and their regulator ... over a long period of time ... will always make the right decisions at the right time.

So, instead of hoping that these risks will be competently managed ... we also need a "fail-safe" system where if any one large institution fails, the system carries on without breaking down. We need to reduce systemic risk by limiting the size, complexity, and concentration of our financial institutions.

We need to create regulatory and economic disincentives aimed at limiting the size and number of systemically important financial firms. For example, we need to impose higher capital requirements on them in recognition of their systemic importance, to make sure they have adequate capital buffers in times of stress.

We also need to impose greater market discipline by creating a legal mechanism for the orderly resolution of a large troubled institution.

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The ad-hoc response to the banking crisis is because we don't have a playbook for taking over an entire complex financial organization. As we saw in the case of Lehman Brothers, bankruptcy is a very messy way to go.

As you know, the FDIC has that authority but only for insured depository institutions. The FDIC has the experience and manpower to handle the task of taking over a large a nonbank institution. We need a special receivership process that is outside bankruptcy, patterned after the one we use for insured banks and thrifts.

To protect taxpayers, a new resolution regime should be funded by fees charged to systemically important firms, and would apply to any institution that puts the system at risk. These fees should be imposed on a sliding scale, so the greater the risk, the higher the fees.

In a new regime, roles and responsibilities must be clearly spelled out to prevent conflicts of interest. For example, Congress gave the FDIC backup supervisory authority and the power to self-appoint as receiver when banks get into trouble. I hope Congress acts soon. Nobody wants to go through another banking crisis like this one, and another ad hoc response.

One way to organize a system-wide regulatory monitoring effort is through the creation of a systemic risk council (SRC) to address issues that pose risks to the broader financial system. Based on the key roles that they currently play in determining and addressing systemic risk, positions on this council should be held by the U.S. Treasury, the FDIC, the Federal Reserve Board and the Securities and Exchange Commission. It may be appropriate to add other prudential supervisors as well.

The SRC would be responsible for identifying institutions, practices, and markets that create potential systemic risks, implementing actions to address those risks, ensuring effective information flow, completing analyses and making recommendations on potential systemic risks, setting capital and other standards and ensuring that the key supervisors with responsibility for direct supervision apply those standards. The standards would be designed to provide incentives to reduce or eliminate potential systemic risks created by the size or complexity of individual entities, concentrations of risk or market practices, and other interconnections between entities and markets.

The SRC could take a more macro perspective and have the authority to overrule or force actions on behalf of other regulatory entities. In order to monitor risk in the financial system, the SRC should also have the authority to demand better information from systemically important entities and to ensure that information is shared more readily.

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The creation of a comprehensive systemic risk regulatory regime will not be a panacea. Regulation can only accomplish so much. Once the government formally establishes a systemic risk regulatory regime, market participants may assume that the likelihood of systemic events will be diminished. Market participants may incorrectly discount the possibility of sector-wide disturbances and avoid expending private resources to safeguard their capital positions. They also may arrive at distorted valuations in part because they assume (correctly or incorrectly) that the regulatory regime will reduce the probability of sector-wide losses or other extreme events.

To truly address the risks posed by systemically important institutions, it will be necessary to utilize mechanisms that once again impose market discipline on these institutions and their activities. For this reason, improvements in the supervision of systemically important entities must be coupled with disincentives for growth and complexity, as well as a credible and efficient structure that permits the resolution of these entities if they fail while protecting taxpayers from exposure.

What is the status of the PPIP program now? You’ve said that banks have been able to raise a lot of capital privately.

Banks have been able to raise capital without having to sell bad assets through the LLP, which reflects renewed investor confidence in our banking system. As a consequence, banks and their supervisors will take additional time to assess the magnitude and timing of troubled assets sales as part of our larger efforts to strengthen the banking sector. As a next step, the FDIC will test the funding mechanism contemplated by the LLP in a sale of receivership assets this summer. This funding mechanism draws upon concepts successfully employed by the Resolution Trust Corporation in the 1990s, which routinely assisted in the financing of asset sales through responsible use of leverage. The FDIC expects to solicit bids for this sale of receivership assets in July. The FDIC will continue its work on the LLP and will be prepared to offer it in the future as an important tool to cleanse bank balance sheets and bolster their ability to support the credit needs of the economy."

You’ve voiced concerns in the past about whether the amount of funds in the FDIC will be adequate to cover potential banking losses. What do you think about this now? The U.S. banking industry has the willingness and capacity to provide the necessary backing to the insurance fund. The entire capital of the banking industry stands behind the fund, as does the full faith and credit of the United States government. The public can be sure that we will always have enough money to protect their insured deposits.

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Growth in insured deposits and a shrinking fund balance caused the Deposit Insurance Fund's reserve ratio to decline from 0.36 percent of insured deposits to 0.27 percent in the first quarter. Insured deposits increased by $82.4 billion (1.7 percent) during the quarter. The DIF balance declined from $17.3 billion at the end of 2008 (amended from the originally reported unaudited balance of $19 billion) to $13.0 billion on March 31, 2009. However, the FDIC Board of Directors approved an amended restoration plan in February that is designed to restore the DIF reserve ratio to 1.15 percent within seven years. The FDIC has already set aside $28 billion in reserve to cover projected losses for the next 12 months. In addition, the FDIC will collect more than $8 billion in premiums during the second quarter, including $5.6 billion from the special assessment the FDIC Board approved on May 22. In addition, Congress recently raised the FDIC’s borrowing authority from the Treasury from $30 billion to $100 billion. This additional tool will provide the FDIC flexibility – in combination with the FDIC’s assessment plan. The big news of course is that you and the FDIC are agitating to shake up Citigroup’s top management, including the possible replacement of Vikram Pandit. What is the status of this now? The FDIC does not comment on open and operating institutions. What concerns do you have about how large Citi’s potential losses could be, its ongoing health, and how much U.S. taxpayers are backstopping it? According to publicly available information, Citi has approximately $300 billion in insured deposits, about $62 billion in TLGP backed debt and an insurance wrap on $300 billion in assets that the FDIC has potential exposure for $10 billion.

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BAIR IN FORBES Intelligent Investing with Steve Forbes

The Need For Failure Thomas F. Cooley, 05.27.09, 12:01 AM EDT

If a firm is ''too big to fail,'' it is ... too big.

There has been constant chatter about the fact that our regulatory institutions don't really know how to deal with firms that are deemed "too big to fail" but may be insolvent. Throughout 2008, policymakers improvised a solution for each case that came along--Bear Stearns, Fannie and Freddie, Lehman Brothers, AIG. But improvisation is not a policy, and the weakness of that approach has become increasingly apparent as we drag through 2009.

First, the very notion of "too big to fail" is dangerous. It suggests that there is an insurance policy that says, no matter how risky your behavior, we will make sure you stay in business. It encourages banks to get bigger (or more interconnected), and it subsidizes risky behavior.

Second, it leaves ambiguous the important issue of who gets protected in the event of insolvency--the equity holders, creditors, subordinated debt holders, etc. It seems fair to say that the solutions that have developed on the fly have done severe damage to the notion that there is a well-ordered capital structure that means something.

In recent weeks, two very independent voices have stepped forward to argue for the creation of mechanisms for taking over and shutting bank-holding companies and other large systemic institutions. Sheila Bair, chairman of the FDIC, has argued that the absence of an authority to shut failing systemic banks has cost the American taxpayers dearly because of the unprecedented government intervention in the financial sector.

Thomas Hoenig, president of the Federal Bank of Kansas City, has also been arguing a very similar position. In testimony before Congress and in several speeches, Hoenig has said that the notion of "too big to fail" should be eliminated from the public dialogue. If insolvent firms are not allowed to fail, it undermines the roll of markets in disciplining economic behavior.

The recent stress tests of 19 banks might have been expected to add some clarity to this issue if some banks were found to be too undercapitalized to continue to operate. Instead, the tests had just the opposite effect. The Treasury gave the banks that need more capital until June 9 to raise it. But it also signaled that, if required, it could provide more capital to those banks that cannot raise all that they need. In effect, it treated all 19 as "too big to fail."

We find ourselves in this peculiar state of affairs because we are paralyzed by the very size and interconnectedness of the institutions that are insolvent or undercapitalized. Yet as Bair rightly pointed out, the FDIC has had lots of experience with the problem of resolving

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commercial banks that are in trouble. In the current year to date, 40 banks have failed in the U.S., and the process has been extremely orderly.

When an FDIC-insured bank or thrift is at risk of failing, the FDIC has a standard set of rules that are invoked. If a bank is approaching insolvency, the FDIC gives formal notification of its undercapitalized status and the need for a plan to address the issue. Typically, it is then very swift at assessing the bank's health, organizing a sale, and helping the bank to close or re-open its doors under new ownership.

Sometimes, when there are more complicated issues, the FDIC operates a bridge bank for a period to keep essential services flowing. For instance, it has special resolution authority to prevent immediate close-out of an insured depository's financial contracts. It has 24 hours after appointment as receiver to decide whether to transfer the contracts to another bank or to an FDIC-operated bridge bank.

Unfortunately, after more than a year of financial turmoil, there is still no resolution mechanism for bank holding companies. The lack of a resolution mechanism has required the government to improvise for each individual situation, making it very difficult to address systemic problems. What we need is a process that imposes losses on equity holders, unsecured creditors and others without triggering domino effects in the financial system. At the same time, the financial plumbing needs to keep working.

In my last column, I argued that a greatly empowered and more independent FDIC might be the best candidate to be the systemic risk regulator. It would be charged with measuring and pricing systemic risk and, most importantly, collecting insurance fees from those institutions that create it. It seems only natural to think that such an organization should also have the expanded responsibility to resolve and shut large systemic institutions.

One great advantage of having a well-articulated responsibility located in one institution like the "Super FDIC" is that it could have the authority to separate bad assets from good assets on an institution-by-institution basis rather than drag out that process with Rube Goldberg-like structures such as the Public-Private Investment Program--PPIP.

At the end of the day, the most important issue here is that we must demonstrate that we will not tolerate the continued existence of zombie banks dependent on taxpayer guarantees and handouts. Perhaps it was tolerable to use taxpayer money to prop up these institutions as an interim solution in the worst days of the crisis--but two years in it is not. We are bankrupting our children because we do not have the political will to address this challenge.

Thomas F. Cooley, the Paganelli-Bull professor of economics and Richard R. West dean of the NYU Stern School of Business, writes a weekly column for Forbes. He is a contributor to a new book on the financial crisis entitled Restoring Financial Stability (Wiley, 2009). His Forbes.com columns are archived here.

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Wall Street Short-Sellers Set For Flame Forum Liz Moyer, 05.27.09, 01:40 PM EDT

Banks could be in the cross hairs at much-watched Sohn investment conference.

One year ago, David Einhorn of Greenlight Capital took to the stage at an annual investor conference in New York and skewered Lehman Brothers, claiming its feckless risk taking had put the financial system in peril.

His talk ended with a call to regulators to guide Lehman "toward a recapitalization and recognition of its losses--hopefully before federal taxpayer assistance is required."

The speech was, of course, a sensation. And Einhorn, who was public about taking a short position in Lehman's stock (hoping it would decline in value), proved prescient. Its pronouncements about its viability notwithstanding, Lehman collapsed into bankruptcy just four months later.

That same conference, the Ira W. Sohn Investment Research Conference, convenes Wednesday afternoon in Manhattan, and Einhorn is scheduled to speak again. He will present his best investment idea for this year, as will fellow short-seller James Chanos of Kynikos Associates and activist William Ackman of Pershing Square Capital, among others.

It is a big event in the hedge fund world--investors pay $3,000 a seat to hear ideas from big-name money managers and at the same time raise funds to treat children with cancer and other deadly diseases.

The contents of the speeches are kept secret, and media outlets are asked to embargo stories on what was presented until noon the following day. This year, an anonymous donor bought 50 seats for attendees who otherwise couldn't afford it because of unemployment.

Banks could well be the short-sellers' target again, even though most bank stocks have been badly beaten down since early 2008. Chanos is already on record saying banks knowingly booked inflated earnings when selling financial products that led to the financial system's downfall and government bailout.

Earlier this month at a conference at New York University, Chanos called it "one of the greatest heists of all time."

Bank stocks rallied in March and April after reaching a low point in February on concerns that a broader government bailout might be needed to save the likes of Citigroup and Bank of America. But even regulators are saying the banking system isn't out of the woods yet.

The Federal Deposit Insurance Corp. said Wednesday the number of banks on its "problem" list rose to 305 in the first quarter from 252 at the end of 2008; the 21 bank failures in the

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period were the most in one quarter since the end of 1992, and that count doesn't include last week's failure of $13 billion asset BankUnited of Coral Gables, Fla., the biggest collapse so far this year.

Troubled loans are accumulating, and losses continue to rise as income falls. The industry's ratio of reserves to loans rose to an all-time high of 2.5%, surpassing the previous high set in 1992 in the midst of the last real-estate lending crisis. But the increase in reserves isn't keeping pace with the deterioration in loan books.

The ratio of reserves to non-current loans fell to 66% from 75%, the lowest level since 1992. "We are now in the cleanup phase for the banking industry," says FDIC Chairman Sheila Bair. "It will take some more time."

That should give short-sellers more than enough ammunition.

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Stress Tests For Most Banks, Not Too Stressful Joshua Zumbrun and Liz Moyer, 05.07.09, 06:25 PM EDT

Federal regulators determine 10 of 19 big banks need to raise capital; BofA, Wells Fargo and Morgan Stanley to sell new shares.

WASHINGTON, D.C. -- Federal regulators have determined that after a relatively successful first three months of 2009, the largest 19 banks only need to raise $75 billion to remain well-capitalized through a prolonged downturn.

The government's so-called "stress tests" relied on estimates of how different classes of loans would perform in a prolonged recession, and then evaluated the portfolios of the 19 largest banks to determine how large their losses might be. The results will require some banks to raise additional common equity as a buffer against recession.

The banks that do not need additional capital will be able to begin the process of repaying TARP funds, provided they demonstrate an ability to raise private debt.

The government has determined that nine banks do not need additional funds: American Express, BB&T, Bank of New York Mellon, Capital One, Goldman Sachs, JPMorgan Chase, MetLife, State Street and US Bancorp.

Of the $75 billion the other 10 banks need to raise, the bulk of the obligation falls on Bank of America, which was judged to require $33.9 billion; GMAC, which needs $11.5 billion; and Wells Fargo, which needs $13.7 billion according to the tests. Citigroup needs $5.5 billion.

Fifth Third Bancorp, KeyCorp, Morgan Stanley, PNC Financial Services, Regions Financial and SunTrust Banks need to raise sums under $2.5 billion.

After the government's announcement, Wells, Bank of America and Morgan Stanley said they would sell new common shares. Bank of America also said it was considering the sale of certain businesses, but added it saw no need for new injections of government money. That has been a sticking point for Kenneth Lewis, Bank of America's chief executive, who was stripped of the title of chairman last week after shareholders lost confidence in his leadership. "We are comfortable with our current capital position in the present economic environment," Lewis said Thursday.

In the most adverse economic scenario tested in the exercise, the government determined the banks stand to lose $600 billion on loans in the next two years, with poor performance for many loan classes. The adverse scenario assumes losses as high as 20%, including as high as 28% from subprime mortgages and 16% from second mortgages. The complete report is available on the Federal Reserve's Web site.

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Comptroller of the Currency John Dugan, one of the regulators who conducted the stress tests, said that credit losses at banks are likely to increase in the coming months, and said this was a "severe test."

By guaranteeing debt banks sell to help fund their lending operations, the Federal Deposit Insurance Corp. lowered the cost of borrowing for banks, boosting the profit margin from lending out at higher rates. At a certain point, banks will be able to overcome more than a year of losses from deteriorating assets with strong revenues and profits from traditional banking activity.

Surprisingly strong first-quarter profits at many of the top banks--driven by trading in interest rate and other fixed-income products--were probably also no accident. Banks can build capital and reserves for future losses through excess earnings, helping them to avoid going to the market to sell securities.

Banks are expected to use a variety of strategies to meet the government's demands for more capital, including the sale of assets and business units. Bank of America could sell its Columbia Management fund business for $3.4 billion, analysts at CreditSights say, as well as more of its stake in China Construction Bank or other operations. The bank is also expected to be allowed to offset its estimated capital need with excess earnings this year. It had a bang-up first quarter, with $4 billion in profits.

Citigroup separated its solidly performing commercial and retail banking divisions from other less-solid businesses, like mortgage lending, that it no longer wants. It sold a majority interest in its Smith Barney brokerage operation to Morgan Stanley and is looking to sell or unwind those other operations.

From the beginning, the government's response to the financial crisis has been more of a confidence restoration project than anything else.

The buildup to Thursday's results began in February, when Treasury Secretary Timothy Geithner first announced the stress tests, along with plans for a sweeping overhaul of financial regulation. Since then, everyone has been focused, almost obsessively, on what the stress tests themselves would say.

What they won't say is how Washington is going to fix the problem, a question that is still very much up in the air. The fact that banks were under-capitalized, given their complexity and the nature of the businesses they are in, has been no secret.

The stress tests "don't change what has to happen," says Joshua Siegel, managing principal at StoneCastle Partners. "Banks have been operating on too little capital for too long." The fix, he says, is going to take time.

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There is a regulatory push to dismantle the financial conglomerates that got the world into this mess in the first place. FDIC Chairman Sheila Bair on Wednesday told the Senate Banking Committee, "A strong case can be made for creating incentives that reduce the size and complexity of financial institutions, as being bigger is not necessarily better."

Brian Wingfield contributed reporting.

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Capital A Captive FDIC Thomas F. Cooley, 04.15.09, 12:01 AM EDT

Has another regulator caved in to the banking industry?

The most successful policy response to the banking crisis of the 1930s was the creation of the Federal Deposit Insurance Corp., which resulted from an amendment to the Glass-Steagall Banking Act of 1933. President Franklin D. Roosevelt opposed the creation of the FDIC, as did many leading bankers in the big money centers.

Nevertheless, this one institution was responsible for calming the fears of depositors and ending bank runs. Its creation was followed by many decades of relative stability in the financial system. Now, the integrity of the FDIC is threatened by pressure from those it is meant to regulate.

The Banking Act required that all banks that were members of the Federal Reserve System have their deposits insured, up to a limit, by the FDIC. Other banks could also be covered, subject to approval by the insurer. Insured banks were required to pay premiums for their insurance based on their deposits. Within six months of the creation of the FDIC, 97% of all commercial bank deposits were covered by insurance.

The FDIC has been a successful institution because it solved a well-defined problem--uncertainty about the solvency of the banks. More importantly, it did so in a way that acknowledged the contradictions and risks inherent in fractional reserve banking by making those responsible for the risks pay for insuring against them.

As is always the case with regulation, the institutions regulated by the FDIC have sought over the years to minimize the cost of FDIC insurance. One example of this occurred in the aftermath of the Savings and Loan Crisis of the 1980s, when the Savings Association Insurance Fund (SAIF) was taken under the umbrella of the FDIC.

Insurance Rates for SAIF were much higher than those for commercial banks under the Bank Insurance Fund as a result of their recent history of failures. The result was that banks worked hard to qualify as eligible for the lower-premium BIF.

Banks also lobbied Congress hard to limit the size of the insurance fund. These were set at 1.25% of insured deposits. It wasn't until passage of the Federal Deposit Insurance Reform Act in 2005, when some flexibility was introduced into the formula, that insurance rates could be tied to risk assessments of the institutions. Following those reforms, the requirement was that the insurance fund stay between 1.15 % and 1.5 % of all insured deposits.

For many years, including the recent boom years of ever-increasing profits and risks, the banks paid nothing into the insurance fund. And then came the crisis.

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Twenty-five banks failed last year, and 23 have failed so far in 2009. Some of the failed institutions--IndyMac, for example--were very large. The reserve ratio as of Dec. 31, 2008, was 0.4%, down from 1.22 % at the end of 2007. It has fallen further since. FDIC Chair Sheila Bair has warned that the fund could quickly be wiped out if more fees are not assessed on the banks.

The FDIC has proposed significant new premiums as well as an emergency assessment that could collect up to $27 billion. And how have the banks responded? With howls of anguish and increased lobbying efforts to get the FDIC to back off. The banks' claim is that we cannot expect them to pony up more when they are weak, and would will be forced to raise fees and curtail lending.

Sadly, the FDIC has caved, asking Congress for the authority to borrow $500 billion from the Treasury (read: from taxpayers) in case they need it. This is a dramatic increase over their current statutory limit of $30 billion. If they get the line of credit, they will cut back the fee increases. Unfortunately, this changes the game, once again shifting risk to taxpayers rather than the creators of the risk.

The FDIC has also been expanding its mission throughout the crisis. In October, it introduced the Temporary Liquidity Guarantee Program to guarantee newly issued senior unsecured debt of banks, thrifts. For a fee of 75 basis points, the same for all regardless of their risk profiles, banks can issue unsecured debt guaranteed by the full faith and credit of the U.S. government.

This remarkable intervention was justified by invoking the FDIC's statutory authority to prevent systemic risk. What is slightly odd here is that by providing essentially free insurance to these institutions, the FDIC could be substantially increasing systemic risk and the risk to taxpayers.

The FDIC is also part of the plan to insure losses on the Public Private Investment Partnership proposed to help rid banks of their "legacy" assets. Who will pay the premiums for this insurance? Apparently not the investors, and that means the risks will again be shifted to taxpayers.

Successful, well-designed regulatory institutions are a rare thing. The FDIC is a good example of an institution that, for the most part, solved the right problem at the right time in the right way. What a shame if it gets captured by the politicians and the banks.

Thomas F. Cooley, the Paganelli-Bull professor of economics and Richard R. West dean of the NYU Stern School of Business, writes a weekly column for Forbes.

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THE BAIR INTERVIEW Intelligent Investing with Steve Forbes

Steve: Overseas And Overtaxed Hello, I'm Steve Forbes. It's a privilege to introduce you to our featured guest, Sheila Bair. Sheila is the chairman of the Federal Deposit Insurance Corporation, and one of our nation's top finance regulators. She has been candid in asking whether some of our nation's top banking CEOs are really earning their pay. My conversation with Sheila Bair follows but first – Recently the White House announced it was going to crack down on firms that didn't pay U.S. corporate taxes on their overseas earnings. The U.S. is the only large economy that applies its domestic taxes to profits earned in other countries and brought back home. Now the Obama Administration wants to get its claws on that money even if it’s kept overseas and even if companies have paid other taxes on it. We’ve been here before. In the 1970s Consolidated Edison, one of the largest electric companies in the world, nearly went broke. One reason? Greedy New York politicians levied taxes and fees on Con Ed for years, treating this utility like an ATM. But Con Ed was nearly taxed to death. Now, Obama wants to do this to all business. The U.S. already has the second-highest corporate tax rate in the developed world. Because of this, upwards of $700 billion in profits have not been brought home. Yes, firms maneuver to cut their effective tax rates, but why should this be necessary? If we cut corporate tax rates to 20%, or even less, it would result in higher tax receipts. Obama fails to understand that cutting tax rates increases incentives for productive work, risk taking and success. Not just for corporations but individuals. The White House also wants to boost taxes on high-income earners, treating them like Con Ed way back when. Once again, it's astounding how little our president understands of what makes an economy prosper. In a moment, my conversation with Sheila Bair. Banks Will Close Steve Forbes: Sheila, thank you very much for joining us. A broad question to begin with. Sheila Bair: Okay. Forbes: Where is the credit system today? What parts are working and what parts aren't working very well?

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Bair: Well, insured depository institutions are working pretty well. The banks are stable. The deposits are stable. There's a lot of confidence in the FDIC guarantee, so folks are leaving their insured deposits in their banks, and that's a good thing because that's money that they can lend out to support the economy. We still have some challenges ahead. There are still some bad assets on bank balance sheets, still some continuing credit distress from the recessionary environment we're in. So, we have some issues and challenges to work through. There will be more bank closings. But I think if you're insured, there's really nothing for your consumers to be worried about. The FDIC's always been there. Nobody's ever lost a penny of insured deposits. And even if the bank is closed, which is a remote possibility, but even if the bank is closed, they have virtually uninterrupted access to their money. So, it's a good, sound system. And we're just pleased that Main Street's been leaving their deposits in the banks because that's been an important stress of credit for the economy. Forbes: Now, in terms of the credit system itself working and supplying credit, where do you see that? Right now, for example, small businesses say they're having the toughest time. The latest readings since 1982. Bair: They are. Forbes: That the money's just going to big corporations largely. Governments and government guarantees. But the rest of the economy's still struggling. Bair: Right. Well, small business lending has been under some distress. And that's why we think community banks are an important part of the solution here. We want to make sure the government programs to stabilize the system equitably help support the community banking sector as well, because community banks are a very important source of credit, especially for small businesses, particularly in smaller communities and rural areas. So, that is, you know, the higher perceived credit risk, the more you'll see it pulled back. And as bank regulators, we try to emphasize to our banks to strike the appropriate balance. Obviously, we want prudent lending. We want loans that the people will pay. But we do want lending. And so, you know, I think one of the problems with this crisis was banks and non-bank providers. There's certainly a lot of non-bank financial institutions heavily involved in contributing to some of the issues we're seeing now. But credit providers, I think, lost touch with just good old basic underwriting, you know, looking at somebody's financials and what's their credit history like, and had they been reliable in the past. Do they have a good business plan? Can they repay this loan? And doing that kind of old fashioned banking analysis as

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opposed to relying on models or a lot of collateral or whatever. Just looking at the borrower's capacity. The Credit Freeze Forbes: What signs do you see, are there signs, in terms of the credit system really flowing again as it did before the crisis hit? Bair: Well, credit spreads are down. Credit spreads are down. And so that's a good sign. That's a very good sign. So, banks are lending again. We have a temporary debt guarantee program that we made available on emergency basis to banks and bank holding companies in October. And we're scheduled to phase that out in October. But we're seeing banks, more and more, being able to issue unsecured debts. So, the market's coming back willing to extend credit to them without government backing, which is very important. So, we think those are very healthy signs. Bank balance sheets, I'd like to see a little more lending there. A lot has collapsed back into the banking system and more is being asked of banks to extend credit. But I think, for the most part, they are trying to strike that right balance and re-engage in prudent lending. But also, make sure they do lend to credit worthy borrowers because that's very important for the economy. Forbes: How helpful are the amendments in early April and mark to market accounting helped stem the bleeding on bank balance sheets? Bair: Yeah, you know, I think that might've had some impact on the margin. But I think for the most part, liquidity is important to stabilize. And I think we have done that. So, I think it might have helped on the margins. But I think it was not a huge factor. No, I wouldn't call it that. Forbes: Banks now have never had more cash than they've ever had before. Bair: Right, yeah, that's true. Forbes: Huge levels of cash. Bair: Yeah, right. Big Reserves Forbes: Why and when will that cash really start to loosen up? Bair: It's funny. I asked the Federal Reserve that. Our cash is coming from them. Yeah, reserves are quite high right now. And so, again, I think as confidence becomes greater in the banking sector and banks and other financial

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service providers get more confidence about the situation in the economy that more lending will take place to drain down some of that. Of course, the flip side is that then there's too much out there. And then we get into an inflationary situation. So, I think this is an important issue for the Federal Reserve Board right now, a balancing that they need to weigh. And fortunately, it's their job not mine. But I think, you know, I have a lot of confidence in Chairman Bernanke. And I'm sure they are on top of it and will be implementing the appropriate policies as we go forward. Forbes: There's a lot of anecdotal stories about how tough bank examiners are on loans. And putting a lot of cold water on banks. Animal spirits for lending. Bair: Animal spirits, right! Forbes: Has that eased up a little bit? Bair: You know, I think so. We asked a lot of our examiners. Because, again, I think with banks, a lot of it happened outside the banking sector. But some banks were making loans they should not have made, clearly. And they were extending credit where credit should not have been extended, or under terms that were not affordable. So, we needed to stop that. And so, the trick is, of course, is not to recoil so much, go too far the other way and just pull back on credit even when it's a good loan and the borrower's fully capable of repaying it. So, we've tried to communicate that to our examiners that they need to strike this balance in engaging with the banks and we don't want the lax lending of the past but we do want them to lend. We do want them, that's an important function. That's one of the reasons we provide deposits insurance. The key reason we provide deposit insurance is to provide depositor’s safety and give the banks funding to lend into the economy. But it's difficult, you know? One area that we focused on is, for instance, in commercial real estate loans. The value of collateral on the loan may have declined. And it's important to have an up to date appraisal on that collateral. But even if there's been some deterioration of the collateral, if the borrower's credit worthy, is current on the loan, has the financial capabilities to recourse the loan and can continue making the loan that don't classify that loan and don't, you know, restrict on that. So, that's one example of an area where we try to communicate to our examiners to take a balance to approach. But it's difficult, no doubt about it. Forbes: Is there a shoe to drop? We keep hearing on commercial real estate that'll particularly impact regional banks?

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Bair: Right. Well, I think this has been an ongoing, we've been into the commercial real estate losses for some time and I think this will be a significant area for losses for banks this year. But overall, banks still have a lot of capital to absorb those losses. Individual banks will have some trouble. A lot of the smaller ones that we have closed this year have gotten themselves in trouble with commercial real estate lending, particularly construction development, residential construction development. So, that's clearly been an area where we've seen some high losses that have led to some failures. But overall, the banking system has got a lot of capital in it and can absorb these losses as we go forward. An Uber-Regulator Forbes: What is your opinion of the Obama administration's one overarching, super-duper regulator? Bair: Well, you know, I think we'd like a say. I mean, I guess some people think that's trophy or whatever. You know, we insure six trillion dollars in deposits. So, we think we have an interest in the system and its safety. So, if a systemic regulator is created, we would like some role and say in things like capital standards to make sure that we don't have another build up of excess leverage the way we did leading into this crisis. So, we hope we can have a good dialogue with the Hill and the administration on that issue. Another area where we have put more emphasis before a systemic risk regulator is a resolution mechanism. We would like to see the end to “too big to fail”. You know, small banks are being closed all the time and very large financial organizations are not being closed, for the most part. And there really isn't a mechanism to deal with them right now. Forbes: Is this what you mean by systemic risk council? Bair: Well, that's actually something a little different. I think we make a distinction between the ability to resolve a failing institution and a prudential supervisor that is charged with the on-going system. Trying to make sure banks don't fail. Forbes: So, how do we move from “too big to fail” to where they know something can be done? Bair: Well, I think we have a good mechanism that applies to banks right now. And I think it could easily be extended to apply to bank holding companies. And under our test it's a least cost test. So, market participants, creditors, certain creditors, and certainly equity shareholders need to take losses before the government takes loss. We are obliged to follow a resolution that imposes least cost to our deposit insurance fund, which is backed by the government.

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So, and it's a transparent mechanism. It's in the statute, people understand that there's a claims priority. And also, another good thing about our process is that our goal is to return the failed bank or failed institution back to the private sector as quickly as possible. So, it's not like we don't prop them up and run them as a ward of the state. That's not what our resolution system is about. It's about selling off the institution as expeditiously as can be done and getting it back in private hands. And really, for economic revival, we find that that's the most efficient mechanism to take place. Too Big To Fail Forbes: So, how, under this, would, I'm just picking Citi, because Citi is Citi—“too big to fail”. How would a large institution be treated in the future? Bair: Right. Well, I would never comment on open, operating institutions. And, certainly, nothing about this discussion is in any way institution specific. Forbes: Let's call it X Bank. Bair: Okay. Forbes: Huge X Bank. Bair: Okay, so going forward, in the future, I think it is important to recognize a couple of things. We will always have cycles of good times and bad. And this has been an extreme situation because of a lot of things that didn't happen in terms of market discipline and excess leverage and poor lending standards. But I think we need to recognize, no matter how much regulation you have, you will always have cycles. So, having a clean up mechanism that actually works is very, very important. So, again, I think for a large institution it would work much the way it does with the small banks right now. We're typically appointed as receiver or conservator by the primary regulator. We can do two things. If it's a smaller institution, we might have a ready buyer to just take the whole institution. And that's the easiest and cleanest and efficient. And for the smaller institutions, and as well as for WaMu last year, we were able to market it and sell it, had a lot of good buyer interest, and we were able to market and sell it before it was even closed. So, it was a very seamless transition. If the institution is too large to be acquired by a single entity, what generally would happen would be to set up a bridge bank. So, the essential functions of the financial intermediation that needed to be continued, that had franchise value, would be put into a bridge bank, or the good bank, if you will. The bad assets, the toxic stuff, the stuff creating the losses would probably be held back

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at a receivership. The good bank would be spun off to an acquirer as quickly as possible in whole arm pieces. And then the… Forbes: Sort of, a super RTC? Bair: Exactly. That's exactly right. That's exactly right. That's exactly right. And, you know, the mechanism we had back in those days, almost everything was in a bank or an S&L. So, the resolution mechanism worked. But our statute in 1991, since 1991, so much has grown into the shadow banking sector, or the financial activities outside the banks. The resolution mechanism we have now which just applies to banks, does not apply to the broad way financial intermediation that we have now. So, it would be a relatively simple update to our statute for bank holding companies. There are other types of non-bank financial organizations where perhaps you could make the argument you need that type of authority there. If Congress wanted us to take that we would be willing to do that. But at least for bank holding companies, we think it's very important to have that resolution mechanism capability. Systemic Risk Forbes: And what role do you see for something like the systemic risk counsel? Bair: Yeah. Well, I think, you know a couple of things. I think there is absolutely a need to constrain leverage across the board. I think there was a lot of arbitrage between the relatively higher capital standards that banks had and non-bank entities. And I think that absolutely fit into this situation. I also think that there is a Balkanization of jurisdiction. And so, you know, the bank's regulated at one place and the holding company's regulated by another place and if you're a commercial bank you're regulated here and if you're an investment bank you're regulated over here. And what that means is, we can all point fingers at each other and say, "Well, you know, we didn't get those investment banks get lever, the SEC did that." And the SEC can say, "Well, those bank regulators weren't on top of mortgage lending." And so, I think getting us all together in a counsel with a statutory mandate to have accountability and ownership for this system. And we have ownership, we all have ownership of it. And it is our obligation to identify systemic risk and prevent those before they occur. I think it would be a good thing to get us all working together in a cohesive way and sharing information. And in collaborating to prevent systemic risk as opposed to saying, "Well, my little piece is okay," you know, and not worrying about anything beyond that.

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Forbes: How likely is that going to happen, do you think? Bair: Well, I don't know. You know, I think we're really hoping resolution authority can happen this year. This is something we could use now, even with the smaller banks. Many frequently have holding company structures that can make a resolution difficult. So, we're hopeful that that will happen this year. On this broader issue of systemic risk regulator, I think there are a lot of different views about how to do that. So, that may take a little longer. But I don't know if that's necessarily bad. You know, we're still working through the clean up phase of this crisis. We're still learning. I'm still learning. So, maybe taking a deep breath and taking a little more time with it will not be a bad thing. Toxic Assets Forbes: Toxic assets. Where are we, where does that whole thing stand now? Bair: That's a real good question. Yes, yes, yes. Well, you know, much to my delight, banks were able to go out and raise a lot of capital without dealing with their toxic assets. And so, I think there's not a lot of bank interest now in selling assets obviously for the loans. Forbes: Has Treasury gotten the word? You don't have to answer that. Bair: Well -- so, we were only doing the loan piece. There's another part for security. And there may be a different dynamic for the securities. But for the loans, we're going to continue putting the structure together to have it in place should the need arise. And the need may very well arise. So, we're going to go ahead with the structure in place. But right now, there are not a lot of banks motivated to sell because they have been able to raise the capital without doing it. And that was one of the key ideas. But I do think a combination of raising capital and getting rid of the toxic assets overall is a better strategy to get banks lending again. Because as long as the toxic assets stay on their books, their continual drain on earnings is that you have to keep provisioning losses. And just the psychological uncertainty of what the outer realm of those losses will be, I think, maybe instills a certain conservatism in bank lending that you wouldn't have if they just got rid of them. Forbes: On assets for your own institution. Where do assessments stand now and in the future, will we see something based on more risk instead of one size fits all? Bair: Well, you absolutely will do that. This is one of the first things I did when I became Chairman in June of ‘06. We instituted a premium structure that was

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risk based and we keep refining that. We had to do a special assessment recently that was not risk based. It was a special assessment. But in these times, there's only so much we can put on the weaker banks before we start forcing them into resolution. And then that creates another issue of cost for us. Forbes: Is this a situation where, maybe, you don't put assessments on but wait until the system's up and running again, or? Bair: Well, you know, that's been a lot of debate, internally at the FDIC and with the industry. I'm sure some of the banks would prefer if we just started borrowing from Treasury and worried about it later on. I don't think that's wise. We may someday have to borrow. I hope we don't. But, you know, banks have always paid for the deposit insurance. And if we effectively under-priced it knowing we would have to borrow from Treasury, that would just be another tax payer subsidy. And I don't know about you, I don't want another tax payer subsidy into the financial system. So, I'd like to try to avoid that if we can. Shadow Banking Forbes: What is the future of so-called, "shadow banking?" Bair: Yeah. Well, a lot of it's got away. I mean, kind of, when things became so dire last fall, a lot of the shadow banking system collapsed back into the banking sector. And we've had a dramatic increase in insured deposits. And now liquidity is supporting funding. A lot of investment banks and other types of financial entities have now become bank holding companies and are growing their depository institutions because this is a stable source of funding. So, I think the market in itself is a lot of the shadow bank sector is going away just because the Federal safety nets were not there to support it. So, it's collapsing back in. Whether that continues in the future, I don't know. But I think that will be a more gradual process. But if the non-bank sector comes back -- Forbes: That puts even more pressure on banks in the sense that if they don't lend Bair: It does, it does. Forbes: It has repercussions that wouldn't have been true two or three years ago. Bair: That's exactly right. There's a lot more being placed on banks right now. So, you know, I do hope that having different and varied financial intermediaries in the economy is good, so long as we make sure that there's some good, basic common sense regulation that applies across the board. I don't mean a lot of prescriptive regulation, but consistent capital standards to guard against excess

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leverage I think is something that can be done, that some simple rules can apply across the board to help avoid getting in the kind of situation we're finding ourselves in now. Financial WMD Forbes: Let me ask you why did this crisis get so big? If you look at the late '80s, early '90s, you had thousands, literally, of S&Ls, went under. Banks were loaded with junk loans from third world countries. Commercial real estate was in even worse condition than today. Yet, we got through it. Bair: We did. Forbes: And this one posed a mortal risk. Bair: It did. Forbes: Looking back, how did that happen? Because if you look at the bad mortgages and actual real defaults, it's bad but seemed no worse than the crisis that we faced 20 years ago. Bair: So, I think derivatives and structured finance had a lot to do with it. So, even if, you know, you're only having 100 billion dollars of losses or so on a particular category of mortgages, that could be multiplied hundreds of times through all these CDOs and CDO squares, or the mortgages, the original pool of mortgages, the interest in those would be sliced and diced into another securitization, which would be sliced and diced into another securitization. And, of course, you had derivatives trading. CDS markets trading off of the performance of those mortgages as well, with hundreds of billions, if not trillions of exposure there, too. So, I think the losses and then the leverage, the nature of the leverage underlying those instruments also magnified losses when they started going down. It used up returns, but it magnified losses going down. So, I think there is, again, some need for some basic common sense oversight of derivatives as well. More transparency, certainly. More real time. Marking to market every day. Margining every day. Those are the kinds of things you see in the regulated futures markets which function pretty well. There will still be a need for customized instruments, that won't necessarily lend themselves to quite those same strictures. But I think a lot of this can be brought on exchange or exchange-like counterparties that can rely for better transparency and more effective margining. And so, I think that is another big area for regulators to work on. And that will require some legislation, too. But it was really the magnification of losses and the destruction of finance derivatives products.

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Forbes: And finally, what is your bold prediction for the future? Bair: Oh boy. Well, we will get through this. We are getting through this. And, you know, I think we'll emerge better and stronger. I think for both institutions and consumers, we're kind of getting back to basics. So, people are saving more. And I personally think that's a good thing. I think there were consumers, there was too much credit out there. Not enough of that traditional, old fashioned savings culture that I inherited from my parents who lived through the Depression. And so, I think that's positive. And I think for banks, too, banks are getting back to basics in terms of knowing their customers, having prudent underwriting and loans. You don't do anybody a favor if you give them a loan they can't repay. That’s just not in anybody’s interest. So, I think those types of basic American values of economics, home economics and finances as well as institutional principles of finance, I think those are welcome things. So, I welcome that. And I think when we get through that those will serve us well. Forbes: Great. Thank you very much. Bair: Thank you. Nice chatting with you.