"I never once considered it appropriate to put taxpayer money on the line," declared Treasury Secretary Henry Paulson at the time.
Privately, top officials had been predicting that a Lehman bankruptcy would hardly come as a surprise. Its trading partners and creditors had known for months that Lehman was in a death spiral. Everybody had had time to prepare.
Wrong. It turned out that a major money-market fund, Reserve Primary Fund, had been holding $785 million in Lehman debt that suddenly became worthless. On Tuesday, Sept. 16, one day after Lehman filed for bankruptcy, the Reserve fund "broke the buck" — meaning that the value of its assets sank below $1 a share — and it couldn't fully redeem clients' shares. That sparked an epic run on all money-market funds, with institutional investors withdrawing nearly $450 billion in a matter of days. That threatened to cripple the huge "repo" market, which supplies trillions of dollars in overnight cash loans to Wall Street securities dealers. Before the week was out, the Treasury was guaranteeing money-market funds, and Paulson was asking Congress for an all-purpose $700 billion bailout fund.
People still disagree about whether the government could or should have saved Lehman. But there is no debate that its collapse set off a catastrophic chain reaction that almost nobody had predicted. It also revealed hidden weaknesses in the financial "plumbing," the maze of institutions that move money between investors, savers, borrowers, and the "real economy."
Darrell Duffie, the Dean Witter Distinguished Professor of Finance at Stanford Graduate School of Business, was shaken as well. Over more than two decades, he had analyzed many pillars of the system: credit risk, securitization, "dark markets," and financial derivatives, to name just a few. Yet the financial crisis showed how little he and other academics had looked at the system as a whole.
"We academics hadn't connected the dots very well," he said recently. "You really needed to step way, way back and think broadly. You need to understand how everything connects together, but that in itself is far from sufficient. You need to understand the underlying forces."
Since then, Duffie has been on a mission. Though still a theorist and an educator, he has plunged into the nitty-gritty debates about fixing what he calls the "pipes and valves" of modern finance. He shuttles regularly to Washington and New York, advising (without charge) officials at the Treasury, the Federal Reserve, and other regulatory agencies. He writes prolifically, from academic papers to books. And as an active member of the Squam Lake Group, a nonpartisan group of finance academics, he has pushed for reforms in financial regulation.
It doesn't always go smoothly. Duffie infuriated some liberals last year by criticizing the "Volcker rule," which would prohibit banks from trading for their own accounts. More often, however, Duffie's ideas provoke heated opposition from the financial industry.
What makes Duffie influential is his grasp of both granular detail and the big picture. To read his papers is to get a lucid and jargon-free tour of the financial infrastructure and its most urgent problems. Duffie doesn't fire off broadside attacks on "Wall Street" or "big banks." He describes the system as it is, untangles its knots, and then zeroes in on the biggest sources of trouble.
"I see each situation, and I try to disentangle it," he said. "It's very clinical, very dispassionate."
Closely Examining the Infrastructure
Much of Duffie's current focus is on financial "utilities": overnight repo markets, central clearing systems, and exchanges and swap facilities for financial derivatives.
Like water systems and electrical grids, financial utilities operate in the background and attract little attention. But like electrical grids, they can unleash havoc if they break down.
Exhibit A on a Duffie tour of the plumbing is the $2 trillion-per-month tri-party repo market, a huge source of short-term funding that attracted almost no public attention before the 2008 crisis.
A repo, or repurchase agreement, is essentially a very short-term loan, usually for one day and usually secured by a bundle of securities. The big Wall Street dealers use repos to finance their enormous inventories of securities, and the biggest dealers often borrow more than $100 billion each on a single day.
To institutional investors such as money-market funds, repo loans seemed ultrasafe before the crisis because they lasted for only a day. But the daily "unwinding" and "rewinding" became so routine that the giant Wall Street firms effectively used them to finance long-term needs. Repo transactions peaked at about $2.8 trillion per month before the crisis. When the market froze in 2008, the Fed — and taxpayers — became Wall Street's lenders of last resort.
The repo market has since revived, but Duffie argues that it still poses big dangers. Two major banks, JPMorgan Chase & Co. and Bank of New York Mellon Corp., provide virtually all the clearing and settlement for repo transactions. The two clearing banks also provide vast amounts of interim credit to the dealers, mainly to cover the time between the expiration of one day's loans and the creation of new loans for the next day. This intra-day lending can easily top $100 billion for a single dealer — a lot of money, even for JPMorgan. It can also create a serious conflict of interest: JPMorgan itself is the nation's biggest securities dealer, and has its own capital needs.
Duffie's attention to the risks was sharpened when he was engaged as a consultant to the Lehman estate, the legal entity that administers the liquidation of Lehman's assets. Lehman alleged that JPMorgan's aggressive actions as a tri-party repo clearing bank aggravated Lehman's troubles in its final days.
Putting Lehman aside, Duffie argues that the structure of the repo market poses a fundamental threat to financial stability. It's not just the volume of money involved. It's also the concentration of risk: Wall Street's three biggest broker-dealers — including JPMorgan — account for more than a third of all repo lending.
"That is not a good situation," said Duffie. "If a dealer gets into trouble, the clearing bank might end up holding the bag."
In a crisis, then, cash investors might worry as much about the clearing banks as the borrowers, and flee the entire market. If a clearing bank were to cut off credit to a shaky dealer, it could force a fire sale of securities that would aggravate the catastrophe.
The really bad news, according to both Duffie and Fed officials, is that some of these risks are increasing. Indeed, Fed officials recently echoed Duffie's warnings that repo markets may be more prone to "runs" today because the Dodd-Frank financial reform law of 2010 makes it much more difficult for the Fed to provide backup credit if a new crisis arises. Institutional investors, knowing this, may move faster than ever to pull their money out.
"We have not come close to fixing all the institutional flaws in our wholesale funding markets," warned William C. Dudley, president of the New York Fed, in a speech this February. "One could argue that the risks have increased compared to prior to the crisis."
Duffie argues that the repo market is too important to be controlled by banks like JPMorgan and Bank of New York Mellon, given their big roles in many other markets. The more that a clearing system is entangled with major banks, he maintains, the harder it will be for the government to pull the plug on a bank that is "too big to fail." His solution: Create a tightly regulated, stand-alone clearing system with clear-cut rules and no room for discretion.
For the moment, that idea isn't getting much traction. But Duffie and his colleagues are having better luck on a closely related fight: the reform of money-market funds.
Averting Money-Market Mayhem
Duffie is a key member of the Squam Lake Group, an informal group of top financial economists that hammers out recommendations for financial reform. In January 2011, the group warned that the design of money-market funds leaves the door open for destabilizing stampedes like the one after Lehman's bankruptcy.
The problem is that money-market funds, which offer slightly higher returns than insured bank accounts, create the false impression of being as safe as cash or money in the bank. Shares are normally priced at a "stable" net asset value of $1, solidifying the idea that shares are interchangeable with cash. As the Lehman collapse made clear, however, money-market funds can sometimes lose money. If institutional investors fear that a money-market fund may actually break the buck, they have a powerful incentive to pull their money as fast as possible. That leaves retail investors holding the bag, and the giant overnight repo market in deep trouble.
To reduce flight risk, the Squam Lake Group proposed giving money-market funds a choice between two alternatives: They could establish capital buffers to protect against actual losses, or give up the illusion of a stable share price and let fund shares fluctuate with the market value of the holdings.
The idea attracted big support in Washington. Mary Schapiro, then chairman of the Securities and Exchange Commission, championed regulations modeled closely on the Squam Lake plan. The Wall Street Journal, normally hostile to regulation, wrote multiple editorials in support.
But the mutual fund industry blanketed Capitol Hill and individual SEC commissioners with protests. The proposed reforms, declared the Investment Company Institute, would "destroy money market funds, at great cost to investors, state and local governments, business, and the economy." The campaign produced a stalemate among the SEC's five commissioners last August, with two Republicans and one Democrat declining to support the reforms.
Today, the prospects are better. An umbrella group of federal financial regulators, the Financial Stability Oversight Council, essentially instructed the SEC last November to adopt the reforms or explain why it wouldn't. The SEC's new chairman, Mary Jo White, has indicated she wants to pursue the reforms this year.
A Wealth of Reform Opportunities
Meanwhile, other issues beckon. Washington remains bogged down over reforms in trading financial derivatives, from plain-vanilla interest-rate swaps to the credit-default swaps that brought American International Group to its knees.
Duffie would go further than the banks or even the Obama administration in requiring stronger collateral and centralized clearing systems for financial derivatives. Last year, Duffie staunchly opposed efforts by big banks to exempt the $20 trillion market in foreign-exchange derivatives from new clearing rules. To his dismay, the Treasury sided with the banks.
On the other hand, Duffie angered many reformers last year by sharply criticizing the proposed implementation of the Volcker rule. Supporters of the restrictions, named after former Fed Chairman Paul Volcker, argue that proprietary trading by banks exposes taxpayers to undue risk because bank deposits are insured by the federal government and banks have access to emergency lending from the Fed.
Duffie, in a study commissioned by the securities industry, warned that the proposed restrictions would do more harm than good. Prohibiting banks from trading for their own account, he argued, would reduce market liquidity, increase the cost of capital, and ultimately slow economic growth. The restrictions might also spur a migration of trading to comparatively less-regulated market-makers outside the banking system. A better approach, Duffie argued, would be to raise capital requirements for bank trading.
Critics, including economics professor Simon Johnson, of MIT's Sloan School of Management implied that Duffie's arguments were tainted because the Securities Industry and Financial Markets Association had paid $50,000 for the study. But as Johnson himself acknowledged, and as Duffie had prominently disclosed on the study's front page, Duffie had instructed the trade group to donate the money directly to Michael Fox's foundation for fighting Parkinson's Disease. Johnson also attacked the idea that regulators could keep banks from being reckless. "Why would we want to bet the house again on this industry's special interest now being miraculously aligned with our broader social interest?" he wrote in a commentary for Bloomberg View.
Duffie takes the criticism in stride. "I don't think you should determine the quality of an argument based on which side a person seems to be on."
As it happens, though, most of his proposals give the financial industry heartburn.
In March, Duffie and the Squam Lake Group proposed a dramatic new restriction on executive pay at "systemically important" financial institutions. Duffie argues that top bank executives still have lopsided incentives to take excessive risks. The proposal: Force them to defer 20 percent of their pay for five years, and to forfeit that money entirely if the bank's capital sinks to unspecified but worrisome levels before the five years is up.
"On most issues," Duffie said, "the banks would be glad to see me go away."