MR. TOM GJELTENThanks for joining us. I'm Tom Gjelten of NPR sitting in for Diane Rehm. She's on vacation this week. Sheila Bair is the former chairman of the Federal Deposit Insurance Corporation. She served in that post from 2006 to 2011. As head of the FDIC during the height of the economic crises, Bair played a critical role in stabilizing the U.S. financial system. A critic of Wall Street bailouts, she helped shape financial reform by calling for higher capital requirements and measures to end to the too-big-to-fail problem.

MR. TOM GJELTENSheila Bair joins me from a studio in New York to talk about her new book. It's titled "Bull By the Horns: Fighting to Save Main Street from Wall Street and Wall Street from Itself." And you can join our conversation. Our number is 1-800-433-8850. You can email us, drshow@wamu.org. You can join us on Facebook, or you can send us a tweet if you do Twitter. Good morning, Sheila Bair.

MS. SHEILA BAIRGood morning.

GJELTENWe have a multimedia connection here. You're at a studio in New York, but I can see you via Skype, isn't that cool?

BAIRYes. Yes, it is great. Love technology.

GJELTENYeah, really. So let's start with a little sort of civics lesson for our listeners here. Why don't you remind us what the Federal Deposit Insurance Corporation does, how it got started, what's its mission?

BAIRRight. Well, it got started in the wake of the Great Depression when massive lack of confidence in banks that held people's deposits led to widespread runs. Thousands of institutions had to be closed, not because they were insolvent, but because people pulled all of their money out of them. They had what's called a liquidity failure. So the Deposit Insurance -- the FDIC, the Federal Deposit Insurance Corporation, was created to provide a government back stop for Main Street depositors.

BAIRThe deposit insurance limit was raised over the years. When the crisis started, it was a hundred thousand dollars per bank. By the time we ended the crisis, it had been raised to 250,000 which I think, in retrospect, was a good thing. So we just have a long history of supporting people. No insured depositor has ever lost a penny of insured deposits. Banks sometimes fail. Banks sometimes make stupid loans, or do other stupid things, and they become insolvent and have to be closed. But if you're under the insured deposit limits, the FDIC has always been there to protect you.

GJELTENWell, Sheila Bair, as you say, no one has ever lost a cent of deposits due to bank failures, but banks do fail, and managing those bank failures is a very important role of the FDIC.

BAIRIt is. It absolutely is. We had -- I think while I was there, we had about 365 failures representing over 600 billion in assets. Those were the banks that were actually closed, and then there were a couple of large institutions that were stabilized through the bail-out process, not through being closed. But throughout those, insured depositors were completely protected, seamlessly. Within the next business day they always had access to their insured deposits. We put a very high priority on that throughout the crisis.

GJELTENSo banks fail, and I think one the points in your book that you make very clearly, is that this should not be seen as some catastrophe. Banks inevitably will fail because banks, like other institutions take risks, and we shouldn't get all freaked out...

BAIRWell, there are.

GJELTEN...when they fail necessarily.

BAIRWell, no. If it's manageable proportions, yes. There will be the occasional bank failure, and you do want banks to take some risks. You want them to make mortgages, prudent mortgages, but there's always some risk in lending, even very well underwritten loans. And indeed, when we got into the crisis with the terrible recession that we had, you know, early on the bank failures were really caused by banks doing stupid things, but later, you got more into a situation where banks were being hit hard by the economy, especially those which served lower-income neighborhoods.

BAIRObviously, as it always the case, when you get into an economic downturn, the lower-end communities are hit the hardest, and the banks that serve those communities were hit badly too.

GJELTENWell, you arrived at the FDIC in 2006, and speaking of banks doing stupid things, the first thing that you noticed was some very irresponsible lending by mortgage institutions.

BAIRRight.

GJELTENTell us what you found.

BAIRYes. Yes. Well, that's a really good question, you know, and I really credit the FDIC staff. They were on top of it when I got there. I had some background with weak mortgage lending practices for lower income people, what was then being called sub-prime mortgage lending. Back in 2001 and 2002 when I was at Treasury, we had started seeing some really problematic practices, and I tried to work with the Fed to rein those in back then, not without -- not with much success, I'm afraid.

BAIRSo when I came back to Washington after serving in academia for four years, and was briefed by the FDIC staff a few months after I assumed office in 2006, and we could see some real problems developing. But we had incomplete information because most of these bad loans were being sold into securitization trusts. Our information systems were based on what banks held on their balance sheets. These loans were not being held on bank balance sheets.

BAIRA lot of them were originated by -- completely outside the banking sector by non-bank mortgage bankers and mortgage brokers and sold into Wall Street securitization vehicles. So we had to go out and buy a database that would show us what was going on with these loans that were being securitized by Wall Street firms, and we couldn't -- we just couldn't believe what we saw. I mean, you know, underwriting was terrible, little income documentation, the debt to income ratios, you know, the percentage of your mortgage payment of your gross income could be well over 50 percent. It was just over the top.

BAIRAnd then they had these very severe interest rate resets. The worst of these loans were called 228s and 327s. They were heavily marketed in lower income neighborhoods, and the so-called starter rate for the first two or three years was typically eight, nine, 10 percent, and then it would spike up significantly after two or three years to 12, 13, 14 percent. And they were meant to be refinancing vehicles. The borrowers could barely make the starter rate much less the reset, and so they'd always have to -- they'd do the serial refinancing, so, you know, it was the churning version for mortgages, and the produce was designed that way.

BAIRThey have abusive prepayment penalties. We just really could not believe the stuff that I had viewed as predatory back in 2001 and 2002 had really become mainstream and was getting worse. So we -- it was highly problematic.

GJELTENYeah.

BAIRExcuse me.

GJELTENAnd you mentioned securitization. I mean, some of these bad loans didn't even show up as discreet loans, right, because they got chopped up in little pieces...

BAIRYeah.

GJELTEN...and sort of reappeared as -- as almost something else.

BAIRWell, that was -- yes. This just -- this whole thing got so out of control. There was a saying, I'll be gone, you'll be gone, by those who would originate and package these mortgages and sell them off to investors.

GJELTENSo they didn't have to worry whether they were paid off or not?

BAIRRight, exactly. So all the incentives was just generate a lot of volume because you weren't holding any skin in the game, so if the loan went bad later, it was going to be somebody else's fault, not yours. And so that's what we saw. The incentives in 2006, and I couldn't believe it went on well into 2007, was to just generate as much volume as you could, because you were getting paid up front and then you were gone. I'll be gone, you'll be gone. That was the industry saying.

GJELTENWell, this was -- you mention several times that what you saw was that the -- the real victims here were the people that took out these mortgages without realizing what kind of burdens they were taking on. In your book on page 70, and you're there in New York, so I hope you can find it.

BAIRI have it, yes.

GJELTENYou talk about a foreclosure prevention town meeting that you...

BAIRRight.

GJELTEN...attended in Los Angeles where you came face to face with some of these people that were holding mortgages and unable to pay. Would you read that little section of your book, because I think you describe this in very personal terms.

BAIRSure. So "in stark contrast to the arrogance and disdain I confronted on Wall Street, there I saw families with young children, elderly people, working people in their denims or uniforms. No Armani suits in that room. I saw fear, confusion, and exhaustion in their faces. They were caught in mortgages they could not afford, dealing with a complex loan servicing process they could understand. There were no flippers or speculators in that room, just people terrified about losing their homes.

BAIR"Up to that point I had approached loan modifications in the abstract, from a macro economic standpoint. We needed to get the loans restructured to minimize losses and prevent unnecessary foreclosures that would hurt the housing market. Here I was confronted with the human tragedy of the sub-prime debacle. I tried to be calm and reassuring, but the desperation and the faces looking up at me made me want to break down and cry."

GJELTENWhen was that, Sheila?

BAIRIt still does.

GJELTENYeah. Well, that's entirely to your credit, because we need more people that actually feel the pain that comes from policies that we are implementing. What year was that?

BAIRThat was -- that would have been in early 2008, late 2007, early 2008.

GJELTENLate 2007, early 2008. The rest of us didn't even realize at that point what we were on the verge of.

BAIRYes. We didn't. It was building, but there was a lot of, you know, public statements, sub-prime is contained, this is a small part of the market, we can work through it, and that just wasn't the case. And a lot of the problem was, as you noted earlier, that we had the mortgages which were unaffordable, and were going to go bad if we didn't get them restructured, but we also had a lot of derivative instruments, what they call synthetic derivative instruments that were based on how these mortgages performed.

BAIRAnd we had, you know, hundreds of billions of mortgages, had trillions of dollars of derivatives tied to them, and it was like a game of fantasy football as I say in my book. People were just betting on the direction of whether these mortgages would perform or not. So it really was the derivatives, all the -- what we call the structured products, products that were based on how the mortgages were performing, really had cataclysmic results.

BAIRI think if we had just had -- it was bad enough to have to deal with these unaffordable mortgages, but if we had just had to deal with that I think we could have focused on it better. But we had all these derivatives instruments that were going sour at the same time.

GJELTENAnd what -- and did you try to sound an alarm? Because you could see what -- where this could go.

BAIRWell, I did. You know, I really did. We, in early -- well, actually in late 2006 we started calling for stronger sub-prime lending standards. As I recount in my book, there were two types of mortgages that were a problem. One were the subprime and those were really the ones that were marketed heavily to lower income folks, vulnerable folks, people -- there were mortgage brokers that would actually look in neighborhoods for people who had equity in their home, and bad credit history to market these subprime loans, and they were getting them refinanced at a safe 30-year fixed rate, FHA loans, into these toxic instruments.

BAIRThen there was another group of loans, what we call Alt A, and we can probably talk a little bit more of that. Those are really the loans that the flippers were using that, you know, people like to lump all borrowers in one group, and that was not true. There was a lot of very vulnerable, good-faith homeowners that were trapped in this terrible situation.

GJELTENSheila Bair's new book is "Bull by the Horns: Fighting to Save Main Street from Wall Street and Wall Street from Itself." We're going to take a short break. We'll be right back.

GJELTENWelcome back. I'm Tom Gjelten sitting in today for Diane Rehm and my guest is Sheila Bair. She is the former Chairman of the Federal Deposit Insurance Corporation. She's currently the Chair of the Systemic Risk Council and we're going to be talking about that a little later in the program.

GJELTENHer new book is "Bull by the Horns: Fighting to Save Main Street from Wall Street and Wall Street from Itself." And we'd like you to join our conversation. Our phone number is 800-433-8850. You can send us an email to drshow@wamu.org

GJELTENThis is really an extraordinary book, a kind of behind-the-scenes look at what was going on here in Washington as the country was sliding into financial crisis first and then trying to fight its way out of it. And Sheila Bair, you were in a very unique situation in that you served, what, the last two years of the Bush administration and the first two years of the Obama administration.

GJELTENSo you bridged these two administrations there and this entire crisis from the beginning to the end?

BAIRI really did and it was just a struggle through both administrations. We had, as I was saying earlier, we had to fight to get subprime lending standards in place. The FDIC was only the primary regulator of only one of these subprime lenders, Fremont, which we chased out the business in early 2007.

BAIRAnd we tried very hard to get stronger standards and more action by the other regulators, but it was just too little too late. So much of the damage had already been done.

BAIRBy the time, in the summer of 2007, we finally got the new lending standards in place and then we could see that these loans were starting to -- delinquencies and defaults were spiking up significantly in the subprime loans. As the housing market turned, people couldn't refinance out of them anymore and they were defaulting on their payments.

GJELTENWell, Sheila, you talk about trying to get the other regulatory agencies involved in this.

BAIRRight.

GJELTENYou talk about how hard it was and what obstacles you faced trying to get better lending requirements in. I'm really struck by what you wrote in your book. You say this about when you arrived there in 2006, this, the disease was the deregulatory dogma that had infected Washington for a decade, championed by Democrat and Republican alike, advocated by such luminaries as Clinton Treasury Secretary Robert Rubin and Federal Reserve Board Chairman Alan Greenspan.

GJELTENRegulation had fallen out of fashion in both governments and the private sector had become deluded by the notion that markets and institutions could regulate themselves, quite an extraordinary statement from a Republican.

BAIRWell, you know, I've always -- listen, the markets need some basic rules. They need a referee and I do think, you know, the idea of self-correcting markets and free markets got translated into free-for-all markets. Sure, you need to have some basic rules in place and we just forgot that.

BAIRAnd, you know, regulation had fallen out of fashion. Employee morale at the FDIC was very low. When I got there, they had been through some brutal downsizing. The examination process had been streamlined in a way that the examiners were very worried that they weren't giving enough, being given enough time and support to look at banks and bank loans and portfolios to see what was going on.

BAIRSo we had a tremendous. It was, as I say in the book, it was turning the Titanic. We had a tremendous job just to -- on the cusp of when the crisis was starting to unfold, just turning the ship around, hiring staff, empowering examiners to do thorough examinations again, hiring more examiners.

BAIRWe really had a rebuilding process at the same time that we were needing to get ready for this subprime debacle.

GJELTENAnd to the extent that you advocated this kind of re-regulation or more stringent regulation, did you find yourself sort of out of -- I wouldn't say out of the mainstream, but you're almost saying you're out of the mainstream. And were you kind of out of touch with some of your fellow financial professionals?

BAIRYes. Bob Geithner called me the skunk of the garden party. You know, it's true. I was pretty much alone on a lot of this, if not most of it. It was -- in another really big fight we had was on bank capital and I know people's eyes glaze over when you start talking about capital for banks, but I spend a lot of time explaining why capital is important and if there's...

GJELTENTake about 30 seconds and explain it right now.

BAIRI will. So basically bank capital is the bank's own skin in the game. The people that own the banks, the amount of their own money they have to put up to support the bank's operations versus money that they borrow, right?

BAIRSo if you use a lot of money to -- borrowed money to take your risks as opposed to putting your own money into it, you say that the institution is over-leveraged. They're using a lot of borrowed money instead of their own money. And they take more risks with borrowed money so getting those capital levels up is really important, especially when a lot of that borrowed money is in the form of insured deposits that is guaranteed by the FDIC.

GJELTENAnd what you want -- yeah, I was going to say, what you wanted was to make sure that banks set aside a certain amount of capital that they couldn't invest as a kind of a reserve, a capital reserve.

BAIRWell, right. It's kind of -- capital is what we say has loss-absorbing capacity. Capital is really a way -- there are two different basic ways a bank can fund its operation. It can issue equity. It can issue stock and people own the bank, that's called equity and that's loss absorbing.

BAIRYou buy stock. The issuer does not have any obligation to pay you back. On the other hand, if you buy debt, the issuer has an obligation to pay back the debt and if they can't, they fail. That's what it means to fail. So if you start having unexpected losses, if you have a lot of your funding from capital, from equity holders, they have no legal right to be paid back. So we say it's loss-absorbing and it is.

BAIRBut if you borrow a lot of money -- and that's exactly what happened to these investment banks and Citi Group too, was using too much borrowed money to fund its operations and they got into a situation where they couldn't make good on their credit obligations.

GJELTENYou write this, Sheila, looking back one of the saddest things about the financial crisis is that it could have been so easily avoided with a few common sense measures.

BAIRIt really could have, yeah.

GJELTENIf we'd raised capital requirements you say during the good times we would have averted many failures.

BAIRWe really would have, but instead it was just the opposite. The investment banks, the SEC let the investment banks take a lot of risk. The amount of money they were borrowing versus the amount of their own money they were putting in was about 33 to 1, a 35 to 1 ratio.

BAIRWith commercial banks, most of them, Citi was an outlier here. Their leverage was more of a 12 to 1, 10 to 1 ratio so they had a lot more capital, a lot more of their own skin in the game there, which tempered their risk-taking, but also was available for loss absorption when the housing market started to turn.

BAIRIf we'd done that, we had mortgage lending standards and if we had not, if Congress had not removed the ability to oversee derivatives, just those three things would have really averted most of this. You know, you always will have downturns, but, you know, you don't usually have cataclysms and this was close to a cataclysm.

GJELTENNow, you say Congress is supposed to represent the people and how do you explain the fact that Congress was even an obstacle for you during that time?

BAIRWell, they really were. I mean, sometimes we did get some help on the capital standards from both Senator Dodd and Senator Shelby and I do appreciate that because we needed help because we were fighting all the other regulators. They were all wanting to lower big banks' capital levels.

BAIRAnd so we did get some support from the Hill on that so it's not always that. But frankly, though, all too often, it is that Congress will put pressure going the other direction. I mean, a classic case was when Brooks Leborn tried to suggest we needed some oversight of off-exchange derivatives markets and Congress responded by taking her authority away. And in fairness to Congress, both Alan Greenspan and Bob Rubin recommended that they take that step.

BAIRBut Congress can be heavily influenced by these financial interests and they don't always have the technical expertise, or their staffs don't, to challenge and question and exercise independence of judgment. And so I do -- I think that's an overriding theme of this book is that all of Washington, whether it's the regulatory apparatus or the Congressional process, that financial interests have just become too influential.

BAIRThe balance of power between the public interest and the bank's interest has become skewed. And we saw that with the bailout policy. So the bailout policies were primarily, get the banks, you know, profitable again and they're going to take care of everybody else and that just didn't happen. It was a fallacious way to look at things.

BAIRAnd when I still hear these rationalizations now, well, the bailout has made money. Well, yeah, so the banks got their profits and they gave us a little bit of that so we're supposed to feel good about that. I don't. I think this was a terrible way to have to respond to this and I think everybody in Washington should be working singularly, focused to make sure it never happens again.

GJELTENWell the first big institution to fail was Bear Stearns and you write this. "On Friday, March 14, 2008, when I received an early-morning call from one of our senior examiners advising me that Bear Stearns would be declaring bankruptcy that day, investment banks fail I told him and I went back to sleep for another precious 30 minutes before getting up to go to work."

GJELTENYou had a very relaxed attitude about bank failures, explain that.

BAIRWell, I did. I mean, I'm a traditionalist like Paul Volcker. I think commercial banks take insured deposits. They're in the safety net. They're primarily supposed to be about lending and supporting credit needs. And there are some special procedures that we use for insured banks.

BAIRWe have a resolution process which is very strict and harsh, as in the bankruptcy process, but it does give us some latitude to fund a bank to keep it operational as it is resolved, wind down or sold off. So and there's a lot of rules that go around that, as there should be, a lot of rules and prohibitions on bailing out shareholders and creditors.

BAIRSo, you know, investment banks are supposed to go into bankruptcy and especially a smaller firm like Bear Stearns. I had never thought of it as being systemic or an entity if it got into trouble would need or justify government support. And I, you know, I don't question Tim Geithner's and the New York Fed's motives on owning this. I know they were doing what they thought was right, but I just never saw an analysis of why Bear Stearns was systemic.

BAIRYou know, who would have taken losses if they had gone into bankruptcy without an analysis done and was a conclusion reached that would have had a broader impact on the economy? I just never saw that analysis and it still surprises me. But I do think it set up an expectation that the government was going to intervene even with these institutions that were traditionally viewed as outside the safety net.

GJELTENWell, you say systemic and the question of whether a bank was systemic and by that, I'm assuming you mean -- I know you mean that if such an institution were to fail, it would jeopardize the entire financial system or significant part of the entire financial system.

BAIRRight.

GJELTENAre there institutions that, in fact, are too big to fail, in that sense that their failure would jeopardize an important part of the financial system?

BAIRWell, there should not be and I think one of the things we fought for very hard in Dodd/Frank was what's called Title II resolution authority, which applies the same FDIC resolution processes we've had for decades, that works very successfully with banks, to apply those to non-banks as well like a Lehman or an AIG or any other entity that where the regulators have good, strong analysis showing that if they go into a bankruptcy process, traditional bankruptcy, there's going to be a broader impact on the economy.

BAIRBut Title II also requires, and as well as Title I of Dodd/Frank, that these institutions, bank or non-bank, that are viewed as potentially systemic by the regulators have to file what's called living will plans with both the FDIC and the Fed. And those living will plans have to show that they can be resolved in bankruptcy without systemic impact.

BAIRAnd if they can't show that persuasively the Fed and the FDIC are jointly authorized to order them to restructure, to break up, and to downsize whatever. So this is a powerful, new tool that we didn't have before. But again, like, a lot of Dodd/Frank regulators need to use it.

BAIRIt needs to be -- the tools are there to end too big to fail. Regulators need to use it. I think my former agency has done a very good job moving forward with this. You can see the rating agencies have started down-grading large banks. They have said, we haven't eliminated too big to fail, but they have acknowledged that we've dramatically reduced the likelihood that there's going to be future bailouts under Dodd/Frank.

BAIRSo that's progress, but both the Fed and the FDIC need to keep forward progress on that.

GJELTENSheila Bair, her new book is "Bull by the Horns: Fighting to Save Main Street from Wall Street and Wall Street from Itself." I'm Tom Gjelten. You're listening to "The Diane Rehm Show".

GJELTENSo 2008, you're there, it's the end of the Bush administration, the beginning of the financial crisis that fall, with the bankruptcy of Lehman Brothers. You do not leave. Hank Paulson leaves, the treasury secretary. You do not leave. Did President Obama specifically, personally, ask you to say on?

BAIRWell, there's an interesting story behind that. The Treasury Department, the Secretary of the Treasury is part of the administration and it is traditional and appropriate for cabinet secretaries to step down when a new administration come in. It's the president's prerogative to appoint his own team, obviously.

BAIRWith independent regulatory agencies like the FDIC, it's a little different. The tradition is more for chairmen to serve out their terms. But I was -- I didn't want to stay in my job if I wasn't wanted in my job and so I reached out early on to Rahm Emanuel who was the president's chief of staff and I told him I'd like to stay. I'd like to keep working on these issues, but you know, I didn't want to -- I was happy to go too, quietly and easily, if that's what they wanted.

BAIRAnd so Rahm was very reassuring and said, no, he was sure people wanted me to be part of the team. And then a couple of days later, there was a story leaked saying that Tim Geithner was trying to push me out. So I didn't know what to make of that.

BAIRI reached out to Tim to try to find out what was going on and didn't get very far with those conversations.

GJELTENHe didn't really want to talk about it, did he?

BAIRWell, no, you know, Tim and I have had our ups and downs and I think communication has never been perhaps what it should be between the two of us. You know, reading the Sorkin book and the Wessel book, which was, you know, heavily influenced by Fed staff, I was finding that Tim was unhappy about things I didn't even know he was unhappy with me about.

BAIRBut in any event, later, the president -- actually he never -- no, he never picked up the phone and asked me to stay, but he very publically, on a CNBC interview, said he liked me and I had the sense of urgency about these issues that he wanted to see. And people widely assumed that he wouldn't be, you know, publically complimenting me if he didn't want me to stay.

GJELTENWell, you know, just as an outsider here, Sheila, what strikes me as interesting is here you have President Obama coming into office with this kind of, for the people, sort of program. Here you are a Republican...

BAIRRight.

GJELTEN...being carried over and then President Obama appoints Tim Geithner as his treasury secretary and Tim Geithner is certainly, in your telling, much more inclined to bail out the big Wall Street interests and you're there fighting for the little guy. All of this is sort of politically paradoxical.

BAIRIt's upside down, isn't it? Well, it's not traditionally how perhaps issues and views work out, but, you know, I am a market-based Republican. People are surprised when I say that, but markets don't work unless there's some accountability, you know. If you, you know, if you take prudent risk, if you create sustainable value, the market should reward you.

BAIRIf you make stupid mistakes, the market should punish you. And if you don't have that corrective mechanism in the market, you get Crony Capitalism. You get moral hazard. You get a reinforcement of too big to fail. So I wanted to punish these guys. I wanted to show some accountability and the people who had invested in them.

BAIRAnd I wanted more money spent on home owners and I also wanted more focus put on cleaning up the assets of these more troubled banks, getting the bad assets off their balance sheets. Sick banks don't do a very good job of lending. You see that with the way the Japanese dealt with their crisis in the early '80s, their two lost decades.

BAIRThey still struggle because they just propped up their banks instead of making them -- restructuring them and making them clean up their balance sheets. So we had very profoundly different views and it's, you know, I do in -- I think everything that he did, he did what he thought was right. I don't think the emphasis was in the right place and I think one of the reasons our economy is still sluggish is because we didn't restructure the financial system.

BAIRYou know, in 2008, we were in a crisis so I guess I can be more comfortable. I didn't like any of it, but we had no information that. We were lacking a lot of information, let's put it that way. There were a lot of unknowns. Things did appear to be spiraling out of control. We had to act.

BAIRBut in 2009, the system had stabilized and that was really when to tackle these bad loans and we just never did it.

GJELTENAside from Tim Geithner, very quickly, Sheila, did you have support from other members of the administration?

BAIRWell, yes. I mean, I had positive -- and these are all detailed in my book with Valerie Jarrett, Rahm Emanuel, Shaun Donovan. There were a number of people who I had positive working relationships with and, you know, I tried to be notwithstanding my reputation for being difficult, I generally try to get along with people.

GJELTENI'm sure you do and we're going to go more into that experience after this break. Please stay tuned.

GJELTENWelcome back. I'm Tom Gjelten sitting in for Diane Rehm with my guest, Sheila Bair, former Chairman of the Federal Deposit Insurance Corporation and the author of a new book "Bull by the Horns: Fighting to Save Main Street from Wall Street and Wall Street from Itself." And then we're going to devote the rest of the hour to letting our listeners get in on this conversation. Sheila, I have to tell you that Ruth sent us an email. And this is what she says.

BAIROkay.

GJELTEN"It breaks my heart to listen to Sheila Bair. I always thought she should've been, should be Secretary of the Treasury. What a difference it might have made." So that's a nice thought for you this morning.

BAIRThank you, Ruth. That's very nice to hear. Absolutely.

GJELTENWell, Joe, meanwhile, writes, "What grade would you give Tim Geithner and more broadly President Obama on rectifying America's financial problems?" I'm not sure you actually want to give these guys grades, but he goes on -- Jonathan goes on to say, sorry, it wasn't Joe. It was Jonathan. "What must still be done and what or who stands in the way?" What must still be done? What remains undone?

BAIRWell, I have a lot of policy recommendations at the end of the book. We need to get bank capital levels up. We've done some of that through the stress testing process, but we haven't changed the rules. We need significantly higher capital requirements for both insured banks as well as for non-bank financial -- major non-bank financial institutions. We need to use the resolution authorities in Dodd-Frank to either break these institutions up or make them rationalize their business structure so we can clearly separate the insured bank which should be doing lending and traditional banking with the higher risk securities and derivatives activities.

BAIRI worry a lot about the exposure that my old agency has now with the insured deposits which have grown dramatically. I think they are -- the fed is a holding company regulator. I think needs to work with the FDIC to separate these out. And while often should -- the commercial bank and insured deposits from this high risk activity. Those tools are in Dodd-Frank, but they need to be used. I have a lot of...

GJELTENSheila, those of us who are insured depositors don't want to hear you say you're worried about interests.

BAIRWell, your insured deposits will always be protected. And I think the system is stable now. I don't see any new term problems, but I do think this London Whale example with JPMorgan Chase is a prime example. These are something called tranched CDS, derivatives positions, credit default swaps -- tranched credit default swaps. And I won't spend 15 minutes explaining what that is, but I will tell it's very high risk. So high risk that clearing houses will not even except them 'cause they don't know how to manage the risk. They have to be done on a bilateral basis. And insured deposits were being used for this. That's just inappropriate. We should have traditional lending and other credit support functions and commercial banks.

BAIRSure you can get in trouble making a loan, but internally if you're getting in trouble making a loan, it's 'cause you know you made a bad load. You're doing something stupid as opposed to these derivatives, very complex securities where, like, even good managers at JPMorgan Chase is probably one of the better of the larger banks, don't even have a full handle on what they're doing. So I really think that is absolutely key.

GJELTENLet's go now to Steven who's on the line from Boca Raton, Fla. Good morning, Steven. Thanks for calling "The Diane Rehm Show."

STEVENGood morning. Thank you. I guess my question is along the lines of moral hazard. And I'm wondering and have always been curious to know whether or not at the time of the crisis could the government -- did they have an alternative way to act that could have saved the institutions the way the FDIC will save an institution, but not save the people behind the institution, the bankers? That's what bothers me to this day is that all of those big boys walked away with so much cash.

GJELTENWe should point out that moral hazard means when you put incentives for institutions to do stupid things. You're likely to get more stupid things.

BAIRThat's right. Exactly.

STEVENYeah, it would've been nice to see them get burned, you know.

GJELTENOkay. How about that, Sheila?

BAIRWell, yeah, there was no accountability. The legal tools going into the crisis were imperfect. We had a regulatory process and a resolution process for financial institutions that was centered around banks that are insured by the FDIC. Citigroup had a very large insured bank, but it also had a lot of bad activities going on outside of the insured bank. So to try to put it in, you would've had the bank into an FDIC resolution, you would've had the rest of it into a bankruptcy process, which would've been challenging.

BAIRBut nonetheless, I think with -- short of actually closing them, the government had tremendous power as insure their deposits guarantee -- guarantors of their debt, huge capital investments to require that the institution split itself up and put the bad assets into a separate entity and fund it with the -- through the private stakeholders, the shareholders and the unsecured creditors, the bond holders.

BAIRShort of that we could have at least forced them to sell their bad assets. We tried to get something called a PPIF, a public private investment fund, going that would've been a facility where through competitive auction process banks would've had to sell their bad assets at true market values and get them off their balance sheet. We never could get that going. But again if we had just forced Citi to do that, yes, it would've had to take significant losses, but then you would've had a clean bank that would've been in a better position to lend to support the real economy.

BAIRWhen you prop up these, what are sometimes unkindly called, zombie banks, what they end up doing is they just nurse their balance sheet. You know, they work off their legacy loans. They typically -- you know, best you can see with this Citi. Their investments and government backed securities has increased. They're playing it safe while they worked all their bad loans down. They're not in a position. They don't have a clean balance sheet and strong capital to take risk and making new lending. And a downtown, that's what you need. So...

GJELTENMm-hmm.

BAIRAnd this isn't particular to Citi. I mean, you can see again what happened with Japan. When you just prop up these institutions instead of restructuring, this is the kind of sluggishness that you get. And we're still suffering from it.

GJELTENLet's go now to Elee, Eli, Elee on the line from Utica, N.Y. Which is it, Elee or Eli?

ELIEli.

GJELTENOkay.

ELIHi, Sheila. Our...

BAIRHi.

ELIHi. Our Republican representatives are against Wall Street regulations. They despise Dodd-Frank. When asked why we're not doing something about the causes of the recession, they blame the quasi government banks, Fannie and Freddie. They also blame the government's push to supposedly make housing more affordable. Is there any truth to these -- you know, it's really become a Republican party dogma that this is what happened. Any truth to that?

BAIRWell, there is -- yeah, I mean, the idea that some of the government forced all these Wall Street folks, or for that matter Fannie and Freddie, you know, we forced them to make all these bad loans and get all these big bonuses and, you know, yeah, we forced them to take all those millions of dollars in compensation and bonuses doing this. This was greed. This was greed. There were some government policies that facilitated it. I think the GSEs do have a significant accountability here as well. Though not -- you know, people generally accuse Fannie and Freddie of actually buying all of these toxic loans and, you know, putting them through their own guarantee process. That's not what they did.

BAIRWhat they did was they issued debt for very cheap rates because everybody assumed they were implicitly government backed. And then they took the money that they got from that cheap debt, again, leverage, borrowing money, and invested in Wall Street's subprime securities. So they had a nice little arbitrage going there. Nice, fat spreads that made them tons of money for years, but they were really the ones that were feeding the Wall Street securitization machine by buying all of their subprime backed, mortgage backed securities. So I do hold them responsible for that.

BAIRBut this was a symbiotic relationship. You know, to say, you know, it's the GSEs and not Wall Street, or it's Wall Street and not the GSEs. They were both culpable. And, you know, through the GSEs buying the Wall Street securities, they fed the crisis as well. So I think there's plenty of blame to go all along. But for both the GSEs and Wall Street, they were being driven by greed. It was not -- it was not the government saying you need to help poor people buy houses. It was just unadulterated greed.

GJELTENNow, Eli mentioned Dodd-Frank. And that of course was the financial reform legislation that was authored by two Democrats, Chris Dodd of Connecticut and Barney Frank. Tell us what your involvement in that legislation was, whether you supported it and whether you think it actually went far enough.

BAIRWell, now, I mean, Dodd-Frank, we are much better off having it than not having it. And it would be a very, very bad idea to repeal it. You repeal it, you are going to return us to the bailout status quo, the too big to fail status quo. Dodd-Frank has powerful new tools to end too big to fail, to make sure going forward mismanaged institutions are never again subject to taxpayers to risk. Those tools are there and they can be effectively used. I sincerely believe that.

BAIRThere's something called the Collins Amendment which was supported to Susan Collins, Republican Senator from Maine, that really strengthens capital requirements for large financial organizations, large bank holding companies and large banks, which we didn't have prior to the crisis. I think it's one of the most important -- one of the more important provisions in Dodd-Frank which a Republican sponsored. So there was some bipartisan support for this.

BAIRYou know, I hope that, as I say in my book, there are things in Dodd-Frank I don't like. For instance, we created the systemic risk -- the Financial Stability Oversight Council called FSOC. But it was chaired by the Treasury secretary. And I think that is a bad idea, regardless of who's Treasury secretary, as we said earlier in this conversation, the Treasury secretary is really part of the political administration. They do not have independence in their terms and job protection the way an independent agency does.

BAIRAnd I think bank regulatory decisions, financial regulatory decisions should be made independently. And I wish the systemic council would have its own rule writing authority. So if we're gonna change something, that would be at the top of my list. But we are much -- you know, we are much better off having Dodd-Frank than not having it. It's got important new tools to protect the public going forward. And I just hope Republicans will give this a little more thought and consideration and don't try to throw the baby out with the bath water because that will get us right back into the bailout status quo.

GJELTENWell, speaking of this very issue, I want to read you an email from Christopher. And Christopher is on a -- he says he's on the board of directors of a bank. He doesn't say which bank. He says, "The capital requirements that are proposed by new federal laws coming out are outraging banks. Please discuss why the capital requirements are necessary, in particular, for smaller community banks."

BAIRWell, that's a good question. The bank regulators took a long time to get the new capital rules out. They finally came out in March. In fairness to them, there was a complication with how rating agencies -- Congress eliminated the ability to use rating agencies, rating for any purposes, even corporate debt, which actually they have not done a bad job in those more straight forward debt instruments. So there were some -- a variety of reasons for delay. I think one of them was lack of prioritization. But they did finally get the capital rules out.

BAIRI was surprised. I thought they would tackle the large financial institutions first because that's clearly where the greater leverage is and where the greater risk are if they get into trouble. Instead the tackled the entire industry. And so -- and, you know, you look at small banks, their capital levels, just because they are small enough to fail, their capital levels are much higher than the very largest financial institutions. So strategically I think that was a mistake. There may or may not be a good argument for increasing bank capital requirements for smaller banks, but tackling them all at once I think just the large banks are trying to fend this off and now they've got the small banks in the fight with them, which I think strategically was a mistake.

BAIRThe rules are too complicated too, I'll give you that. So I think, look, I'm great -- it's great the bank regulators are moving forward with higher capital, but they're too complicated and I questions whether they needed to tackle the small banks at this point as well.

GJELTENSheila Bair, her new book is "Bull by the Horns: Fighting to Save Main Street from Wall Street and Wall Street from Itself." I'm Tom Gjelten. You're listening to "The Diane Rehm Show." And let's go now to Deanna who's on the line from Pompano Beach, Fla. Good morning, Deanna. Thanks for calling.

DEANNAGood morning. My question is with loan originators, why it could not be required and have stern oversight that they put skin in the game by maintaining those mortgages for 5, 7, 10 years. What would be the benefit, you know, to the people and maybe harm to the banks since they seem to trade and sell, you know, mortgages at a whim?

GJELTENAnd this goes back, Sheila, to what you said earlier about how many -- too many mortgage lenders have this attitude of all be gone, so what?

BAIRThat's right. So I think risk retention is another thing I support strongly in my book and the policy recommendations. Even when a loan is securitized, there are reasons to -- you know, securitization properly structured can work. It deals with the problem of interest rate risk. So a bank originated a 30 year loan. You know, rates right now could be, you know, three, four percent loan. What happens if interest rates go back up? It keeps loans on the balance sheet. They're going to lose a lot of value. So being able to move the mortgages off into securitization vehicles where pension funds, investment funds that have very long-term investment horizons who can manage the interest rate risk, that's a helpful thing to have for the banking system.

BAIRBut they need to retain some skin in the game. Dodd-Frank said, so if you originate and sell a loan into a securitization, for every dollar of loss that a mortgage that you put into securitization has, you have to take five cents of it. I'd go ten, but I think five cents does -- you know, you do enough volume, that does increase some significant additional incentives to originate more prudent loans. You know, there's another, not five years, but something called reps and warranties to basically say if a loan goes bad within the first few years after origination, it is presumptively assumed to be a bad loan and has to be sent back to the originator or the securitizer.

BAIRSo I think both of those approaches are very powerful, and frankly would probably do more to discipline mortgage lending than these very prescriptive rules saying we can do this and this and this, you know, try to spell out exactly in detail how a loan needs to be originated forcing people to take their own losses, suffer their own consequences, so their decision making can be a lot more effective.

GJELTENLet's go now to Randy who's on the line from Elk Heart, Ind. Good morning, Randy. Thanks for waiting. I know you've been on the line a long time.

RANDYGood morning. Two quick questions. First, if Morgan Stanley, Merrill Lynch, Lehman Brothers had still been partnerships with partners personally liable for losses, would that kind of thing have happened? And secondly, I've seen notional values bandied about of around $500 trillion. If the transaction taxed on those of one percent, that would be 5 trillion. And if it turned over 10 times a year, that's pretty conservative estimate, that'd be 50 trillion a year.

BAIRWell, that'll take care of our budget deficit problems. That's right.

GJELTENVery quick answer, Sheila. We're running out of time.

BAIRSo, yes, a lot of people have suggested that if you still had partnerships -- again, it gets back to that skin in the game, right, if they still had a partnership model as opposed to passing out this risk to shareholders, we would've had better management. I'm sympathetic to transaction tax, not quite that big, but it's in my book if you want to read the policy recommendations. I do support a transaction tax.

GJELTENSo, Sheila, we haven't talked about -- we only got a couple second left. We haven't talked about what it was like -- one of the fascinating things in your book is what it was like to be a woman in the midst of those very testosterone heavy discussions. It was tough at times I guess, huh?

BAIRYes, it was tough. Well, you know, we did -- I did feel like I was being left out a lot, had to claw my way back in. And even when I got into the meeting, we had to fight to have our perspective heard. You know, I don't know if it was gender, if it was the FDIC, it was, you know, (unintelligible) I went to public schools, I'm not part of the Ivy League crowd. I don't know. It can be a lot of things with a lot of different people. But it certainly was a struggle, but, you know, we fought hard. And I think we didn't get everything that we wanted, but we did get -- I think a lot more loans got modified than would've been if we hadn't advocated strongly. And some of the rules are a lot tougher too because of our advocacy.

GJELTENWell, the whole story is in your book "Bull by the Horns: Fighting to Save Main Street from Wall Street and Wall Street from Itself." My guest has been Sheila Bair. I'm Tom Gjelten sitting in for Diane Rehm. Thank for listening.

ANNOUNCER"The Diane Rehm Show" is produced by Sandra Pinkard, Nancy Robertson, Denise Couture, Susan Nabors, Rebecca Kaufman, Lisa Dunn and Megan Merritt. The engineer is Tobey Schreiner. Natalie Yuravlivker answers the phones. Visit drshow.org for audio archives, transcripts, podcasts and CD sales. Call 202-885-1200 for more information. Our email address is drshow@wamu.org. And we're on Facebook and Twitter. This program is a production of WAMU 88.5 from American University in Washington, D.C. This is NPR.