Too Big to Fail

by Andrew Ross Sorkin

  In a videoconference presentation from New York, a PWC executive updated the board on its dispute with AIG over how it was valuing or, in Wall Street parlance, “marking to market,” its portfolio. Goldman executives considered AIG was “marking to make-believe,” as Blankfein told the board.

  Strangely, however, no one in the room in Moscow made the critical connection; no one raised the collateral dispute as evidence of a potential fatal flaw in Goldman’s consideration to merge with AIG—that the company itself was in serious trouble and had resorted to overvaluing its securities as a stop-gap. Instead, the afternoon session proceeded with upbraiding PricewaterhouseCoopers: “How does it work inside PWC if you as a firm represent two institutions where you’re looking at exactly the same collateral and there’s a clear dispute in terms of valuation?” Jon Winkelried, Goldman’s co-president pointedly asked.

  It was the second time PWC had been criticized during a Goldman board meeting. Goldman’s board had first learned of the collateral dispute with AIG in November 2007. At the time, the sum involved was more than $1.5 billion. Nervously, Goldman started buying up protection in the form of credit default swaps—insurance—against the possibility that AIG would fail. Given that no one at the time seriously thought that would ever happen, the insurance was relatively cheap: For $150 million, Goldman could insure some $2.5 billion worth of debt.

  The Goldman board ended its day in St. Petersburg in a more leisurely manner. With the northern sky still light well after 10:00 p.m., the thirteen directors and their spouses rode gondolas along the city’s storied canals.

  On Sunday, the board flew down to Moscow for the second part of the meeting, gathering at the Ritz-Carlton, on the edge of Red Square. Mikhail Gorbachev was the speaker at their dinner that evening. Power in Russia was still very much in the hands of Vladimir Putin, even though Dmitry Medvedev had recently been elected to succeed him. Many foreign investors feared that Russia’s commitment to open and free markets was quickly fading, particularly in light of the power grabs in the energy industry.

  Gorbachev, who had initiated the changes that led to the end of communist rule, struck several Goldman directors as oddly deferential to the Kremlin. “Russia is now realizing its potential as a democratic state, opening itself up to new ideas and outside investment.”

  Some directors joked that if the last hotel wasn’t bugged, this one certainly must be.

  In a strange coincidence, late that afternoon another key figure in American finance arrived in Moscow. Treasury secretary Henry Paulson had come there on a stop on a five-day European tour that would later take him to Berlin, Frankfurt, and then London.

  He had been on the road a great deal that month—visiting the Persian Gulf states; attending the Group of Eight meeting of finance ministers in Osaka, Japan; and now passing through Europe and Russia. The highlight of his trip, he hoped, would be London, where he had been preparing to give what he believed would be an important speech at Chatham House, an international affairs research group, in St James’s Square. Crafted with the help of his lieutenant David Nason, the talk would herald a proposed overhaul of financial regulation. As he continued to be concerned about firms like Lehman, he knew he needed to call for new tools to deal with troubled institutions. He wanted to get ahead of the problems while things still seemed stable.

  On the flight over he had reviewed the speech, making last-minute changes, knowing that he’d have little time to do so once he arrived in Moscow. “To address the perception that some institutions are too big to fail, we must improve the tools at our disposal for facilitating the orderly failure of a large, complex financial institution,” he planned to say. “As former Federal Reserve chairman Greenspan often noted, the real issue is not that an institution is too big or too interconnected to fail, but that it is too big or interconnected to liquidate quickly. Today our tools are limited.”

  It was a risky gambit to announce to the world that the government lacked the authority to prevent a major failure—such a sentiment could undermine confidence in the markets even further—but he also knew that it needed to be said, and even more so, that the situation needed to be fixed.

  On Sunday night, Paulson had dinner with Finance Minister Alexei Kudrin in the Oval Dining Room at Spaso House, the residence of the American ambassador in Moscow. On Monday he had scheduled a busy day, including half a dozen meetings, a radio interview, and private sessions with Medvedev and Putin. Paulson had earlier told reporters that he wanted to discuss with the Russians “best practices” for huge state-owned investment funds known as sovereign wealth funds, which were primarily associated with wealthy Middle East nations.

  But before he ended his evening on Saturday, he had one last meeting after dinner. Just days earlier, when Paulson learned that Goldman’s board would be in Moscow at the same time as him, he had Jim Wilkinson organize a meeting with them. Nothing formal, purely social—for old times’ sake.

  For fuck’s sake! Wilkinson thought. He and Treasury had had enough trouble trying to fend off all the Goldman Sachs conspiracy theories constantly being bandied about in Washington and on Wall Street. A private meeting with its board? In Moscow?

  For the nearly two years that Paulson had been Treasury secretary he had not met privately with the board of any company, except for briefly dropping by a cocktail party that Larry Fink’s BlackRock was holding for its directors at the Emirates Palace Hotel in Abu Dhabi in June.

  Anxious about the prospect of such a meeting, Wilkinson called to get approval from Treasury’s general counsel. Bob Hoyt, who wasn’t enamored of the “optics” of such a meeting, said that as long as it remained a “social event,” it wouldn’t run afoul of the ethics guidelines.

  Still, Wilkinson had told Rogers, “Let’s keep this quiet,” as the two coordinated the details. They agreed that Goldman’s directors would join him in his hotel suite following their dinner with Gorbachev. Paulson would not record the “social event” on his official calendar.

  That evening, the Goldman party boarded a bus to take them the dozen or so blocks to the Moscow Marriott Grand Hotel on Tverskaya Street. Some felt as if they were taking part in a spy thriller, what with the security detail and the grandeur of downtown Moscow. The directors walked through the bright lobby with its large fountain and were escorted upstairs to the Treasury secretary’s rooms.

  “Come on in,” a buoyant Paulson said as he greeted everyone, shaking hands and giving bear hugs to some.

  For the next hour, Paulson regaled his old friends with stories about his time in Treasury and his prognostications about the economy. They questioned him about the possibility of another bank blowing up, like Lehman, and he talked about the need for the government to have the power to wind down troubled firms, offering a preview of his upcoming speech. “Nonetheless,” he told them, “my own view is that we have tough times ahead of us, but based upon history, I think we may come out of this by year’s end.”

  It was that comment that Blankfein recalled the following day to a director over breakfast. “I don’t know why he’d say that,” Blankfein said quizzically. “It can only get worse.”

  CHAPTER TEN

  One afternoon in late June, Dick Fuld stepped into the bustling lobby of the Hilton Hotel on Sixth Avenue at Fifty-third Street. He was late, which made him even more anxious about the meeting he was about to attend. Within days of Bart McDade’s being named Lehman’s new president, he had made a startling demand of Fuld: He wanted to rehire Michael Gelband and Alex Kirk, the two senior traders Joe Gregory had fired. The men, whom Gregory used to call the “the naysayers,” were among the most vocal opponents of the firm’s escalation of risk over the years.

  “We need these guys,” McDade had told Fuld, regarding his decision. “They already know the positions,” referring to Lehman’s portfolio of toxic assets, which they still hoped to sell. And McDade said that both of them had the support of “the troops on the trading floor,” which was critical in restoring confidence. />
  McDade hadn’t given Fuld much choice in the matter. And, given that Fuld had just handed McDade authority over the day-to-day operations of the firm, he felt he had to go along with his wishes for the good of the firm, as embarrassing as it might be to have his own judgment challenged so publicly. Before he did, however, he told McDade, “Look, you’re not hiring either guy back until I talk to them.”

  Now Fuld was on his way to a face-to-face with Gelband, whom he hadn’t seen in over a year.

  The tension was palpable as they both took seats in a dark meeting room. “We need to clear the air,” Fuld said, acknowledging that there was still some unfinished business to resolve. “Let’s understand: You’re coming back. I want to fucking hear from you.”

  Gelband, a broad six-footer with a closely shaved head, didn’t appreciate Fuld’s aggressive tone and had no patience for bullying or bluffing. As far as he was concerned, he was doing Fuld a favor by returning amid the turmoil. Indeed, ironically enough, before agreeing to come back to Lehman he had been recruited to take Joe Cassano’s job at AIG.

  “How’s that, Dick?” he asked.

  “The last time we talked, okay, not the last time, but when you were at the firm and you and I talked about your bonus, I got the sense that you were unhappy with it, and that pissed me off, because you made a shitload of money in 06,” Fuld said, pouring himself a glass of water.

  Gelband thought this was an unusual way to begin a meeting that he believed had been intended as something of a reconciliation. They had had a frank discussion about his bonus the year that he left, when he had earned more than $25 million, but he didn’t remember having complained about it too vociferously. “That’s interesting, because I didn’t have a problem with my bonus,” Gelband said. “In fact, I was completely fine with it.”

  “Well, that’s not what Joe told me,” Fuld said.

  For a moment they set aside their differences and talked about the firm, reminiscing about the better times and reviewing Lehman’s prospects. It was clear the company would have to unwind its positions as quickly as possible and try to get the best possible price for them. Gelband said he would have to conduct an inventory of the assets to get a sense of their value. Fuld also told him that it was his intention to raise additional capital.

  “There is just one thing you need to understand,” Gelband said as the meeting was coming to a close. “The one reason I am coming back is because of Bart.”

  As Fuld knew, Gelband had been a longtime friend of McDade’s; they had been classmates at the University of Michigan Business School, and it was McDade who had helped Gelband get his initial job interview at Lehman. “Well, yes, Bart is going to be running the day-to-day business,” Fuld said, trying to sound nonchalant, “but I hope it has something to do with me as well.”

  Gelband looked at him quizzically and replied, “No, no. This has to do with Bart.”

  On the Fourth of July weekend, Hank and Wendy Paulson were walking along the beach on Little St. Simons Island when they spotted a loggerhead sea turtle laying its eggs in the sand. For nature lovers like the Paulsons, it was an extraordinary moment, and they stopped to marvel at the sight. Paulson had flown down to the tiny island, just off of Georgia’s coast and some sixty miles south of Savannah, to relax with his wife after what had seemed like a whirlwind of travel and work. The island, a sanctuary for unusual birds and reptiles, is where he liked to go to clear his head; he liked it so much that the Paulsons bought up three quarters of the ten-thousand-acre property starting in 2003 for $32.65 million.

  The European trip had been a success. His speech in London about the need to build a safety net for investment banks in order to prevent a failure from reverberating throughout the system had attracted a great deal of notice, and at the reception afterward at 10 Downing Street, Gordon Brown, the prime minister, congratulated him “for thinking ahead and getting out in front of the problem.”

  Still, as Paulson walked the shore, he was finding it difficult to unwind. He continued to have deep misgivings about the economy in the near term and had stated as much on his trip: “The U.S. economy is…facing a trio of headwinds: high energy prices, capital markets turmoil, and a continuing housing correction.” Apart from his general systemic concerns, though, Paulson’s immediate worry was Lehman Brothers. He had spoken to Fuld from his cabin on the island earlier in the day, and it was becoming clearer to him that the firm was unlikely to find a buyer. Most of the large sovereign wealth funds in the Middle East and Asia had been stung by investments they had made in other U.S. banks back in December and wouldn’t be likely to invest in Lehman, at least not in the present. Paulson feared that Fuld could soon run out of options.

  However much these concerns preoccupied Paulson, he kept them to himself; he never discussed business with Wendy. The topic of Lehman was off-limits within the family for another reason: Hank’s younger brother, Richard Paulson, worked as a fixed-income salesman in Lehman’s Chicago office. They purposely avoided discussing the matter whenever they spoke, but he knew that if Lehman were to fail, his brother could lose his job.

  Paulson was also grappling with another potential setback: He might be losing his deputy, Bob Steel, who was on the short list to run Wachovia, the giant Charlotte-based bank that had just ousted its CEO after reporting a $708 million loss tied to the housing market. Paulson and Steel had talked about the prospect in June, when things were calmer, and Paulson had even encouraged him to pursue the position. But now it looked as if it was actually going to happen, leaving Paulson with a big hole to fill. The timing could not have been worse: Steel’s jurisdiction included Fannie Mae and Freddie Mac—the government-sponsored enterprises (GSE) that had been the engine of the real estate boom and were now becoming undone.

  By the time Paulson had flown back home on a private chartered jet to Dulles Airport on Monday afternoon, his worst fears were being realized. The financial markets were in a meltdown, but for reasons Paulson could not quite put his finger on. Freddie tumbled as much as 30 percent on Monday, before recovering to end down 17.9 percent. Fannie shares slid 16.2 percent, to their lowest level since 1992. Other financial stocks were suffering as well; Lehman shares closed down more than 8 percent. As he tried to absorb all that, Steel announced that he had gotten the job, and it would be announced publicly on Tuesday.

  At home that night in his living room, Paulson paged through the piles of faxes that had been sent to him by his assistant at Treasury. One of them was the report that had set off the panic: Bruce Harting, an analyst at Lehman Brothers, wrote that revised accounting rules might require Fannie and Freddie to raise an additional $75 billion in combined new capital. The report revived all the fears about the two mortgage giants, reminding investors of how thin a cushion they had if the housing slump deepened. If confidence was eroding in the government-sponsored enterprises—businesses that the market believed had the implicit backing of taxpayers—the entire U.S. economy could be threatened.

  Paulson could see that unease about Fannie and Freddie was growing. On CNBC’s Squawk Box that Tuesday morning, James B. Lockhart III, chairman of the Office of Federal Housing Enterprise Oversight, which regulated Fannie and Freddie, tried to calm the markets: “Both of these companies are adequately capitalized,” he said. “Both of these companies are managing through these issues and have tested management teams.”

  Paulson had a one-word judgment of that assessment that he later shared with his staff: “Bullshit.” For months Paulson and his team had been discussing ways to unwind Fannie and Freddie should a real crisis hit—he considered their situation far more important to the long-term health of the economy than Lehman’s or the other investment banks’. But he knew it was all too easy to get bogged down in the political fighting over the controversial companies that had made home ownership a near right during the boom. With its critics insisting that Fannie and Freddie were neck-deep in the subprime mess, Paulson had a year earlier called the debate over Fannie and Freddie “the cl
osest thing I’ve seen to a holy war.”

  While shares of the companies recovered on Tuesday from the Monday sell-off, both were still trading below $20, and there were other indications of nervousness. Credit default swaps on the debt sold by Fannie and Freddie—essentially, insurance—were trading at levels reserved for companies with credit ratings five levels below their own triple-A ratings, the highest a company could have. Those ratings were, in fact, more a reflection of the government’s implicit backing than the companies’ own fundamentals.

  As Paulson and his staff prepared for a congressional hearing two days hence to discuss the fates of Fannie and Freddie, Steel stuck his head into the conference room next to his office.

  “Okay, Hank. I’m taking off.”

  Paulson glanced up for a moment. “Okay, Bob. I’ll see you later.”

  “No, no,” said Steel. “I mean, this is it. I’m leaving.”

  Finally realizing that Steel was bidding his farewells to the staff, Paulson got up to see his deputy off.

  As they walked down the hall, Paulson joked, “You’re getting out just in time.”

  Virtually from the moment that Congress created Fannie Mae (originally the Federal National Mortgage Association) in 1938, it was politically divisive. A product of the housing slump of the Great Depression and Franklin Delano Roosevelt’s New Deal, the company was formed to buy loans from banks, savings banks, and other lenders in order to promote home lending by reducing lenders’ risk and to increase the amount of capital available for housing. Republicans saw Fannie as a mere sinecure for their political opponents. In 1968, with a federal budget burdened by the costs of both the Vietnam War and the Great Society, Lyndon Johnson began the process of privatizing Fannie. As a sop to its critics, a rival company, the Federal Home Loan Mortgage Corporation, or Freddie Mac, was created in 1970.