News analysis: Investment officer was consulted on bailout

Friday was not Yale Chief Investment Officer David Swensen’s first trip to Washington in recent months — several administration officials consulted him last fall on the financial relief program, he told the News recently.

In an interview on Jan. 19, Swensen revealed his quiet but crucial role in redirecting federal policy. In advising officials to buy stakes in troubled financial institutions, and not deflated assets — such as subprime mortgages — Swensen had a major impact on the strategies that drove the federal government’s expenditure of $250 billion of public money.

Although Swensen’s is hardly a household name, he is widely celebrated in financial circles as the eminent investor who pioneered the shift to alternative assets. He is the investment mastermind who racked up a legendary 16.3 percent average yearly return in the decade preceding 2008.

So, faced with the worst financial crisis since the Great Depression, top policymakers in Washington turned to one of the country’s best financial stewards. As they tried to figure out how to rescue the imploding financial world, they sought Swensen’s help. Swensen said he told government officials last fall that their response to the financial meltdown had been “completely incoherent” and counterproductive. He said he knew a better way.

And they took his advice.

“I’m not going to say who I talked to, but I talked to a number of people that were in the administration and were close to the administration,” Swensen said.

The U.S. Department of the Treasury would not confirm any meeting and would not set up an interview with the outgoing Secretary Henry Paulson. Lawrence Summers, the current head of the National Economic Council and former president of Harvard University, declined to comment Wednesday on Swensen’s role in shaping the government’s response to the financial crisis.

“There are about seven reasons why I’m not going to answer that question,” Summers said during a conference call with reporters.

The policy Swensen suggested became part of the government’s $700 billion financial bailout. That total includes $250 billion for the capital purchases in financial institutions for which he advocated, of which $195 billion have been spent as of Feb. 2.

In meetings last fall, Swensen said he told administration officials that the original idea behind the government’s relief program — to buy up troubled assets, such as bundles of subprime mortgages — was “completely foolish.” It would be impossible to determine what the assets were worth or what the government should pay for them, he said last month.

“There’s no way that the government can figure out what price to pay for these assets which, in many cases, were unique, one-of-a-kind, and the holder of the asset, the troubled financial institution, knows a lot more about the value than some outsider who’s coming in to take a look at it,” he said. “It’s just a completely silly way to deal with the problems of these financial institutions that have weak balance sheets.”

Instead, Swensen said, the government should buy stakes in banks, which is what the administration started doing in October.

“The purchase of preferred shares, I think, puts the government in the right place in the capital structure,” Swensen said. “It’s above the equity, and the equity deserves to be diminished in value because of the disastrous policies that all these financial institutions pursued.”

The problem was, Swensen added, that the government’s initial policy toward banks was not applied with consistency and transparency. As a result, the institutions were not recapitalized in a way that encouraged private investment. The government scared capital away from the markets — the opposite of what the policies should have done, he said.

“The inconsistency in which the government has intervened has actually driven private capital away as opposed to attracting it,” he said. “The mess is bigger today than it otherwise would have been because of the incoherence of government policies.”

The mess was created in the first place by “undisciplined deregulation,” he said, motivated by the belief that free markets always produce the right outcome. In such an environment, which he compared to the “Wild West,” financial institutions took on stunning degrees of risk, while the regulatory authorities “were just completely asleep at the switch,” he said.

The resulting collapse has fundamentally broken the credit markets, Swensen said, and the economy cannot function without reasonable access to credit.

But fixing that problem will be a long, slow process, he said. In the short run, it involves recapitalizing the financial institutions that destroyed their own balance sheets by “filling them up with garbage,” he said.

In order to improve financial regulation, Swensen said regulatory agencies need to start gathering more information.

“We need to go way beyond just looking at the balance sheet,” he said. “The off-balance sheet exposures frequently dwarf the balance sheet exposure, and the regulatory authorities aren’t even measuring the off-balance sheet exposures, much less dealing with them.”

Regulators have only now started to do that, Swensen said. There were prior warnings in the credit crises of 1987 and 1998, but the recoveries were quick, so the underlying issues were never addressed.

“So maybe the silver lining to this cloud will be that there’ll be a sensible regulatory response and regulators will start measuring off-balance sheet exposures as well as on-balance sheet,” he said, “and maybe we’ll end up regulating those institutions that pose potential systemic risks to our markets.”

Swensen’s impact on the government’s response to the financial crisis was apparent before his appointment to the Economic Recovery Advisory Board and even before his secret, informal advising last fall.

One of the government’s very first actions to shore up flailing financial institutions, including banks, said Charles Ellis ’59, an investments consultant and a former member of the Yale Corporation’s Investment Committee, was to use interest-rate swaps — a technique invented by David Swensen during his stint on Wall Street at Lehman Brothers and Salomon Brothers before he came to Yale in 1985.

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