A fas­ci­nat­ing, enlight­en­ing con­ver­sa­tion and debate about the econ­omy with Bill Ack­man, major investor and hedge fund man­ager of Per­sh­ing Square Cap­i­tal Man­age­ment LP, Kate Kelly of The Wall Street Jour­nal, Andrew Ross Sorkin of The New York Times and Joseph Stiglitz, econ­o­mist and a mem­ber of Colum­bia Uni­ver­sity faculty.

Here is the com­plete transcript:

CHARLIE ROSE: The Obama admin­is­tra­tion today took the lat­est step in
its efforts to repair the nation’s bank­ing sys­tem. The Fed­eral Reserve
began releas­ing infor­ma­tion about its stress test on major banks. The Fed
reported that while reserves had sub­stan­tially reduced in some banks, most
had cap­i­tal well in excess of gov­ern­ment stan­dards. The 19 banks exam­ined
hold two-thirds of the assets and more than half the loans in the U.S.
bank­ing sys­tem. The gov­ern­ment pri­vately told bank exec­u­tives their test
results this after­noon. The Fed also released its method­ol­ogy ahead of an
announce­ment of the results in two weeks.

We want to talk about the finan­cial sec­tor, the stress test, all of
this, with a very inter­est­ing group of peo­ple. Bill Ack­man of Per­sh­ing
Square Cap­i­tal man­age­ment, a hedge fund here in New York. Joseph Stiglitz
of Colum­bia Uni­ver­sity, co-winner of the 2001 Nobel Prize in eco­nom­ics.
Andrew Ross Sorkin of “The New York Times,” a reporter and colum­nist. And
Kate Kelly of “The Wall Street Jour­nal.” I am pleased to have all of them
here at this table.

I will begin with you. Tell me where we are in terms of — what do we
know about the stress test? What do we know about the results? What are
they telling us and who cares?

KATE KELLY: Well, there are pre­cious few details that have been
released so far. We’re going to know more I think on May 4th. But what
hap­pened is, the banks under­went these stress tests. They had cer­tain
para­me­ters they were sup­posed to run their mod­els against, run their
port­fo­lios against — assump­tions about unem­ploy­ment and how severe it
would get this year, for exam­ple; assump­tions about losses on the value of
cer­tain hold­ings that were approx­i­mately close to what you saw last year
with the Lehman Broth­ers fail­ure. And the Fed met indi­vid­u­ally with the
bank man­age­ment today. I think it was CEO, CFO, other senior peo­ple, risk
offi­cers, to dis­cuss where they stood, how strong they were — I think they
had three buck­ets from strong to weak — and whether they would need to
raise capital.

So what’s inter­est­ing is, there has been much back and forth about how
much to dis­close, and I don’t think we fully know what they are going to
dis­close yet. But what they do will have a major impact on pub­lic
per­cep­tion. And even if they don’t give us all the details, based on who’s
rais­ing cap­i­tal, we’re going to be able to make some assumptions.

CHARLIE ROSE: Yes.

KATE KELLY: So the gov­ern­ment is in a bit of a box.

CHARLIE ROSE: All right, Andrew, add to that.

ANDREW ROSS SORKIN: Well, so the issue this after­noon — I talked to
a num­ber of the exec­u­tives who have been briefed on their sta­tus, if you
will — and the ques­tion right now is what assump­tion the gov­ern­ment used
for their rev­enue, right? They did all these other assump­tions which they
used for every­body across the aboard, but what they didn’t do — they
actu­ally for each bank indi­vid­u­ally said what is their rev­enue going to be
for the next two years. And that’s the most fun­gi­ble, if you will, of all
of these, because every bank thinks they’re going to have higher rev­enue
than the gov­ern­ment seems to think. And so what we’re going to be see­ing
over the next week is a debate pri­vately, that hope­fully will come out in
pub­lic at some level, over what those rev­enue judg­ments are, and — and
that’s– that’s what we’re going to find out. And that to me will tell us
in the end who’s strong and who’s not, and who we can actu­ally believe.

CHARLIE ROSE: OK, but it will tell us that, and then what will
happen?

WILLIAM ACKMAN: It depends.

(LAUGHTER)

WILLIAM ACKMAN: The answer is, the banks that need more cap­i­tal,
where does the money come from?

CHARLIE ROSE: Exactly.

WILLIAM ACKMAN: And the last six months, the money has come from the
tax­payer, and the ques­tion is if that is going to con­tinue. And there are
some alter­na­tives in the taxpayer.

And this past week­end, Larry Sum­mers was on “Meet the Press,” and he
talked about asset lia­bil­ity swaps as alter­na­tive means to raise cap­i­tal
for banks. I trans­late asset lia­bil­ity swap for debt-for-equity swap,
junior debt-for-equity swap, pre­ferred stock for equity swap.

Basi­cally, what’s inter­est­ing is that the banks in this coun­try have
all the cap­i­tal they need. The prob­lem is too much of that cap­i­tal is in
the form of debt, not enough is in the form of equity. The way we solve
that prob­lem typ­i­cally in Amer­ica is through a reor­ga­ni­za­tion process,
where a judge adju­di­cates a bank­ruptcy or some other form of
con­ser­va­tor­ship or reor­ga­ni­za­tion. They fig­ure out the value of the firm.
They fig­ure out how much equity needs to be raised, and they com­pro­mise
with the bond hold­ers until the bond hold­ers end up own­ing the firm.

What you can do instead is Bill the bond holder has to con­vert $50
bil­lion of his debt into equity, and that mag­i­cally raises $100 bil­lion of
cap­i­tal, because for each dol­lar of debt that becomes equity, you’re
can­cel­ing a dol­lar of debt, you’re cre­at­ing a dol­lar of equity. And the
sys­tem is really set up for this. This is a clas­sic restruc­tur­ing
approach.

CHARLIE ROSE: OK, why haven’t we tried this before? Is this — do
you think this idea has merit? This idea of Ack­man and Larry Sum­mers
talk­ing about it publicly?

JOSEPH STIGLITZ: It’s what I said they should have been doing all
along.

CHARLIE ROSE: Oh, this was your idea?

JOSEPH STIGLITZ: No, what I’m say­ing is, it is what we have done. We
did it in Con­ti­nen­tal Illi­nois, we’ve done it in — what they’ve con­fused
is the notion of too big to fail with the notion of too big to be
finan­cially reor­ga­nized. And this is just a sim­ple process of finan­cial
reor­ga­ni­za­tion. We do it all the time.

The bond hold­ers don’t like it, because they would pre­fer the
tax­pay­ers giv­ing them money. It’s per­fectly under­stand­able. And the bond
hold­ers have been — their voice has been heard very clearly, but it’s not
in our national inter­est. The banks would be stronger after they do this
kind of finan­cial reor­ga­ni­za­tion. They don’t have to pay out every month
all the inter­est pay­ments that they had to pay before. They now have all
the cap­i­tal that — you know, the lever­age right now is huge. So small
change in the value of the assets means that the cap­i­tal is all wiped out.
So now you have more cap­i­tal, less debt. They’re in a bet­ter posi­tion to
go for­ward. It’s basi­cally the notion that we call a fresh start.

CHARLIE ROSE: Right, so what does Mr. Gei­th­ner think of this?

JOSEPH STIGLITZ: Well, they’ve been resist­ing this.

CHARLIE ROSE: Because?

JOSEPH STIGLITZ: Well, the only rea­son I think is because the — a
lot of influ­ence from the bond hold­ers, finan­cial sec­tor bond hold­ers don’t
like it. You don’t have to be a genius to fig­ure out why they don’t like
it.

CHARLIE ROSE: Exactly right. Andrew.

ANDREW ROSS SORKIN: Well, no, I mean, it’s funny, you said Bill the
bond holder. I should say Bill Gross the bond holder from Pimco, and he is
some­one who has had a lot of influ­ence, as have other bond hold­ers, who
have sug­gested that the moment that you effec­tively force these bond
hold­ers to take a hair­cut or to swap out into equity, you are going to
under­mine the entire bond mar­ket and we’re going to see some kind of
cat­a­clysmic dis­as­ter.

Now, I’m not sure that’s the case, and as you’ve seen in other
bank­rupt­cies, we’ve got­ten through that. So at the end of the day, yes,
this would instill more con­fi­dence, but there is other peo­ple on the other
side say­ing that it would kill confidence.

WILLIAM ACKMAN: There is also a lot of mis­un­der­stand­ings. I mean, I
think that if the tax­payer really under­stood that their cap­i­tal was going
in — if you think about a bank that took in $25 bil­lion of TARP funds.
Let’s assume they have $400 bil­lion of debt — that’s a round num­ber for a
sys­tem­i­cally impor­tant bank — $25 bil­lion is enough to pay inter­est on
$400 bil­lion of debt for a year. So banks won’t lend money because they
need that cap­i­tal to pay inter­est on their debts.

I read a study by a guy by the name of Pro­fes­sor David Scharf­stein of
Har­vard Busi­ness School where he said of the $350 bil­lion that was infused
into bank actu­ally didn’t go into banks. Went into.

CHARLIE ROSE: This is the orig­i­nal TARP money?

WILLIAM ACKMAN: Right. It went into bank hold­ing com­pa­nies. Only
some­thing like $17 bil­lion went into the actual banks. And I know this is
a lit­tle tech­ni­cal per­haps for your audi­ence, but I think it’s important.

The com­pa­nies that trade on the stock exchange are called hold­ing
com­pa­nies, and they’re shells. They have debt. They have equity. And
they own the sys­tem­i­cally impor­tant insti­tu­tions. So the thing that we’re
wor­ried about, that we want to pro­tect, the deposit-taking insti­tu­tion, is
actu­ally the sub­sidiary of the hold­ing com­pany. And that’s why these –
that’s why sys­tem­i­cally impor­tant insti­tu­tions are struc­tured this way, so
that there’s the investor entity — I call it the hold­ing com­pany — can be
com­pro­mised. You know, the debt for equity then can be con­verted with­out
an impact at all on the sub­sidiaries. So the thing that guar­an­tees
deriv­a­tives, the entity that lends money, you don’t want — when Lehman
failed, what hap­pened was con­struc­tion stopped, deriv­a­tive coun­ter­par­ties
tore up con­tracts. If they had been a deposit-taking insti­tu­tion, there
would have been a risk.

The beauty here is you can sim­ply just walk your way through the
cap­i­tal struc­ture of the hold­ing com­pany and cre­ate enor­mous amounts of
cap­i­tal. Let me just fol­low it through for what it can do. Imag­ine if we
did this across the 19 — let’s not do it– you don’t con­vert all the debt
into equity. What you do is you set a stan­dard. You say, look, we need
these banks to be extremely well cap­i­tal­ized, which means they need to have
a cer­tain amount of cap­i­tal. We now have all the data we col­lected from
the stress tests. So each bank needs to have — call it 10 per­cent com­mon
equity to total assets, and we con­vert suf­fi­cient amount of debt — you
know, if JP Mor­gan has a bet­ter bal­ance sheet, you con­vert some. Less for
JP Mor­gan, then you pick another insti­tu­tion and (INAUDIBLE) bal­ance sheet.
It’s a very fair process.

Once you do that, if the banks are now over­cap­i­tal­ized and you
restrict div­i­dends and you restrict stock buy­backs, the only way the bank
can earn an ade­quate return on its cap­i­tal is by increas­ing assets. And
what does that mean? It means mak­ing loans.

Now you’ve got 19 banks com­pet­ing to make loans, and it has a huge
impact on the econ­omy, because the aver­age busi­ness­man says, I can’t spend
money today because I have a debt matu­rity and I can’t refi­nance. But if
he has three bankers knock­ing on the door, or 19 say­ing, “I’m going to lend
you money,” they can start spend­ing again, and the econ­omy can recover.

CHARLIE ROSE: Go ahead.

JOSEPH STIGLITZ: Exactly right. I mean, and in a way, it’s so
inter­est­ing, because we’ve been spend­ing our money deal­ing with what
they’re now euphemisti­cally call legacy assets. They used to first call
them toxic waste, toxic assets, then they called them trou­bled assets, and
now the offi­cial term is legacy assets. But that’s backward-looking. And
it hasn’t.

CHARLIE ROSE: Why is that backward-looking?

JOSEPH STIGLITZ: Because it’s look­ing at the loans that were made in
the past.

CHARLIE ROSE: As long as those loans are there, those assets are
there, those toxic assets are there, these banks have a very bad bal­ance
sheet.

JOSEPH STIGLITZ: Yes, but there’s another way of deal­ing with that
problem.

CHARLIE ROSE: Which you can’t — you don’t quite know how to
evaluate.

JOSEPH STIGLITZ: Which is to con­vert the debt — con­vert the debt
into equity. No one knows how to value those risky assets. And what
they’re doing is very sim­ple. They want to take all that trash and dump it
on the U.S. tax­payer. And it doesn’t make it disappear.

CHARLIE ROSE: The orig­i­nal idea, we buy all the toxic assets.

JOSEPH STIGLITZ: That’s right.

CHARLIE ROSE: Under the Paul­son plan, the first Paul­son plan.

JOSEPH STIGLITZ: Exactly. And then they went into buy­ing it in bulk,
and then they — the cur­rent pro­gram is to use the pri­vate sec­tor as the
garbage col­lec­tor and dump it on our backs, but it’s all basi­cally the same
idea.

CHARLIE ROSE: From the begin­ning, the toxic assets have been a huge
prob­lem. So what should we do about them now?

KATE KELLY: I just think there’s a fun­da­men­tal debate going on here
about val­u­a­tion, and I’m not sure what the answer is. But there is
cer­tainly a coun­ter­vail­ing view to what you were say­ing, that indeed these
toxic assets can be marked, and they should be marked lower than where the
banks think they should be, and that’s why the banks don’t want to sell
them.

CHARLIE ROSE: But that raises the ques­tion, if they do that, what
will that mean to the bal­ance sheets of the banks if they have to mark them
lower, and how many banks will we find are in fact at that eval­u­a­tion
insolvent?

KATE KELLY: Prob­a­bly quite a few, which is a scary prospect.

CHARLIE ROSE: And so what do you do then?

JOSEPH STIGLITZ: And that’s why you need to con­vert the debt into
equity. So that — it’s the only way you can do it. If it turns out then
that the banks are right and the toxic assets are worth a lot more, then
the equity of the banks will go up auto­mat­i­cally, and they get fully
com­pen­sated. So the issue here is who’s going to bear the risk of the
uncer­tain val­u­a­tion? And is it the peo­ple who gave the money to the bank
or is it the U.S. tax­payer? And it’s really sim­ple as that.

CHARLIE ROSE: Andrew.

ANDREW ROSS SORKIN: This all points, though, to the issue of
con­fi­dence and what the goal of the stress test was sup­posed to do, which
was sup­posed to be to instill con­fi­dence. We were sup­posed to have this
stress test. We were sup­posed to get the results and we were sup­posed to
say, ah, this is all going to work out.

CHARLIE ROSE: Mean­ing they had enough cap­i­tal to do what they need
(ph) to do.

ANDREW ROSS SORKIN: They had enough cap­i­tal or we knew which ones
were in trou­ble and which ones weren’t, and we were all sup­posed to feel
very good about it. Instead, what I worry about now is that we’re going to
look at the results of the stress test, and it’s almost a lose-lose.
Either you are going to be very real­is­tic, per­haps even too real­is­tic for
many peo­ple, and you’re going to sug­gest that some of these banks really
are either insol­vent or in so much trou­ble that they are going to need
either addi­tional tax dol­lars, beyond by the way tak­ing pre­ferred shares
and swap­ping them for com­mon, or you’re going to decide.

WILLIAM ACKMAN: How about bonds…

ANDREW ROSS SORKIN: Or bonds.

WILLIAM ACKMAN: … into equity.

ANDREW ROSS SORKIN: Or you’re going to decide that the entire process
is a white­wash and you’re going to have no con­fi­dence in the test to begin
with.

KATE KELLY: I think you’re right about that quandary, because
ini­tially, I think peo­ple were excited about get­ting real results. Then
the word leaked out that nobody was going to fail the stress test.
Every­body was more or less in good shape.

(LAUGHTER)

(CROSSTALK)

KATE KELLY: Right. And then the pub­lic reac­tion was, well, are these
stress tests worth the paper they’re writ­ten on?

CHARLIE ROSE: And what is their method­ol­ogy is another ques­tion about
it.

KATE KELLY: How can that be? How can — this is just going to hurt
confidence.

JOSEPH STIGLITZ: And you look at the num­bers when they come out, and
they cer­tainly are not the worst num­bers that one could imag­ine. I mean,
they’re sort of median. But stress is stress. It’s not where the aver­age
is. It’s what hap­pens if.

ANDREW ROSS SORKIN: I mean, they’re think­ing worst case is
unem­ploy­ment at 10.3 per­cent. Hous­ing prices are down.

CHARLIE ROSE: You mean.

ANDREW ROSS SORKIN: The government.

CHARLIE ROSE: The assumption.

ANDREW ROSS SORKIN: The assump­tions built into the stress test assume
three major things. One, that unem­ploy­ment is at 10.3 per­cent.
KATE KELLY: In the worst-case scenario.

ANDREW ROSS SORKIN: In the worst-case scenario.

(CROSSTALK)

KATE KELLY: 8.8 is (INAUDIBLE).

ANDREW ROSS SORKIN: So this is median already in some cases.
Unem­ploy­ment — unem­ploy­ment is at 10.3. We go to.

WILLIAM ACKMAN: House prices.

ANDREW ROSS SORKIN: . house prices at 22 per­cent. Thank you, I
apol­o­gize. And finally, the econ­omy con­tracts by 3.3 per­cent. All of
those are right down the mid­dle. Nobody would argue, I think, that that is
true stress, worst-case scenario.

CHARLIE ROSE: Right. What would true stress be?

ANDREW ROSS SORKIN: Prob­a­bly 11 or 12 per­cent unem­ploy­ment.
Absolutely.

WILLIAM ACKMAN: I think an anal­ogy that I think will help under­stand
this. Think of a bridge that a truck had dri­ven over. The bridge
col­lapses, the truck falls down, kills a thou­sand peo­ple who hap­pen to be
walk­ing under the bridge. When some­thing like that hap­pens, when they go
to rebuild the bridge, that bridge had a 10,000-pound capac­ity; the truck
weighed 9,800 pounds, but stress and oth­er­wise, the bridge collapsed.

What you need to do is — we don’t need well-capitalized banks under a
his­toric def­i­n­i­tion. What we need is extra­or­di­nar­ily well-capitalized
banks. And you have to ask your­self, what is the down­side if the U.S.
bank­ing sys­tem was the best cap­i­tal­ized bank­ing sys­tem in the world? So
imag­ine a world — and using this debt for equity — the beauty of
con­vert­ing debt for equity is it’s not a tak­ing from tax­payer and it’s not
a tak­ing from the bond holder. The bond holder is get­ting exactly what
they own. Right? A bond holder is an owner of a com­pany in the same way
an equity investor. The equity investor.

ANDREW ROSS SORKIN: Except that most bond hold­ers don’t want to do
this.

(CROSSTALK)

ANDREW ROSS SORKIN: Most share­hold­ers don’t want their stock to go
down.

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