The Bailout, and a Keen Eye on Fixed Income

When we stopped by to interview Peter R. Fisher last Monday, the House of Representatives had just voted down a bill authorizing the Treasury to spend up to $700 billion to buy illiquid assets from financial firms. The outcome triggered a 777-point selloff of the Dow Jones Industrial Average. We returned to continue the interview Friday morning. A bailout was approved later that day in a revote on a repackaged plan — yet the index slipped by more than 7% on the week.

We were especially keen on speaking with Fisher, because he straddles two worlds: His office faces the fixed-income trading floor at money manager BlackRock in midtown Manhattan; he also worked in Washington in the upper reaches of the Treasury Department. From August 2001 to October 2003, he was undersecretary of the Treasury for domestic finance. Before that, he'd worked 15 years at the Federal Reserve Bank of New York.

Fisher, 52, is now co-head of the fixed-income portfolio group at BlackRock, where he has worked since 2004. For his views on the monumental plan to revive the credit markets, read on.

Barron's: How important was passage of this bill?

Fisher: Very important. Our banking system is going through a consolidation. In addition to the household sector overextending itself with its home mortgages, our banking system overextended itself. It grew its balance sheet faster than its revenues grew, and now it has to shrink back. That's a very painful process. It's really almost an unnatural act for a banking system to shrink. It cuts off credit to the economy.

Having the government sector come along and take some of the assets away from the financial sector — and making it happen more quickly for revenues and asset sizes to get in line — will speed our economy's recovery and the recovery of the financial sector. And it will help us come out of the recession we're probably entering right now.

If Congress hadn't approved this plan, what do you think would have happened?

If Treasury didn't get this authority, it would have taken much longer, in all likelihood, for our banking sector to stabilize. We would have seen a much more painful contraction of lending in the economy as a whole, particularly in the fourth quarter. Credit conditions are going to be tight in the fourth quarter, even with this program — but without it, we would have found the banking sector much more anxious and shrinking its balance sheet. That would have run the risk of causing an even deeper recession than we had to.

Is there anything that concerns you about this bill?

It's going to be complicated for the Treasury to come in with the authority and negotiate with banks, to buy the assets and to have the restrictions on the executive compensation and take the warrants. Not every bank will want to sell warrants in order to sell assets to the Treasury. It will take a while. But the good news is that the market will anticipate it, and get some of the benefit over the coming weeks. Wells Fargo (WFC) is purchasing Wachovia (WB) without any government support. At first glance, that looks like Wells Fargo was comfortable enough that the government program was coming so that they can come in and make a bid for Wachovia without a government backstop.

If you were wearing one of your old hats and working at Treasury or the New York Fed, what would you be doing differently to try to stabilize our banking system?

Let's be clear: The Treasury and the Fed are advancing as fast as they can, and they have been doing a lot of good things, but I would be more focused on investor confidence and less focused on moral hazard. Moral hazard is a real risk; you can't just have the taxpayers absorb everything. But we have to balance our concerns about moral hazard at this part of the cycle with our concerns about stabilizing investor confidence. We need private capital. If I were at the Treasury or the Fed, I would be acutely focused on the need for private capital come in and help stabilize the system.

What other steps need to be taken to get this financial crisis under control?

No. 1: We probably have too many financial institutions in the U.S. Canada only has a few banks; we have 8,000. Canada is one-tenth our size. Maybe we can have more than 30 banks, maybe we can have 300 or 3,000. But there is too much capacity in a whole range of U.S. financial players, which need to be consolidated. Otherwise, the system won't stabilize. Returns on equity and assets are too low.

No. 2: We have to address the rules of the road as to how that consolidation occurs. The next time a financial institution gets closed, we don't want a different set of outcomes between the bondholders, the preferreds and the common stockholders. If you want people to bring capital to bear to support those risks, you've got to know what you are getting into, so you can demand the right hurdle rate for the different parts of the capital structure.

It's also important to have [illiquid assets] roll onto the government's balance sheet. So the Treasury's plan is a good tradeoff for the taxpayer. It would take some losses on investments now versus lost tax revenue later in an even weaker economy.