Too Big to Fail

by Andrew Ross Sorkin

  Fannie and Freddie played the political game even more fiercely than their opponents, spending millions of dollars on armies of lobbyists on Capitol Hill. Each company was a revolving door for the powerful in Washington—both Republican and Democrat. Newt Gingrich and Ralph Reed, among others, worked as consultants for Fannie or Freddie; Rahm Emanuel was a board member of Freddie.

  By the 1990s, Fannie’s chief executive could boast, without much exaggeration, that “we are the equivalent of a Federal Reserve system for housing.” At their pinnacle the two mortgage giants—neither of them an originator of loans—owned or guaranteed some 55 percent of the $11 trillion U.S. mortgage market. Beginning in the 1980s, the two companies also became important conduits for the business of mortgage-backed securities. Wall Street loved the fees it collected from securitizing all kinds of debt, from car loans to credit card receivables, and Fannie’s and Freddie’s portfolios of mortgages were the biggest honeypot around.

  But in 1999, under pressure from the Clinton administration, Fannie and Freddie began underwriting subprime mortgages. The move was presented in the press as a way to put homes within the reach of countless Americans, but providing loans to people who wouldn’t ordinarily qualify for them was an inherently risky business, as telegraphed by the New York Times the day the program was announced:

  “In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980s.”

  The success of the two companies in both the financial and political arena inevitably fostered a culture of arrogance. “[We] always won, we took no prisoners and we faced little organized political opposition,” Daniel Mudd, then the president of Fannie Mae, wrote in a 2004 memo to his boss. That overconfidence led both companies eventually to move into derivatives and to employ aggressive accounting measures. They were later found by regulators to have manipulated their earnings, and both were forced to restate years of results. The CEOs of both companies were ousted.

  Fannie and Freddie were still reeling from the accounting scandals when in March 2008, just days after the rescue of Bear Stearns, the Bush administration lowered the amount of capital the two companies were required to have as a cushion against losses. In exchange, the companies pledged to help bolster the economy by stepping up their purchases of mortgages.

  But by that Wednesday, July 10, 2008, with investors unloading the stocks in droves, it was all coming undone. That afternoon William Poole, the former president of the Federal Reserve Bank of St. Louis, said unambiguously, “Congress ought to recognize that these firms are insolvent, that it is allowing these firms to continue to exist as bastions of privilege, financed by the taxpayer.”

  “Unfuckingbelievable!” Dick Fuld exclaimed to Scott Freidheim as he sank deeper into his office chair.

  Lehman’s stock had opened Thursday morning down 12 percent, to an eight-year low, in response to a rumor that Pacific Investment Management Company, the world’s biggest bond fund, had stopped trading with the firm. Another piece of speculation was swirling that SAC Capital Advisors, Steven Cohen’s firm, was also no longer trading with Lehman.

  “I know it’s not true, you know it’s not true,” Fuld said to Freidheim. “You’ve got to call these guys and get them to put out a statement.”

  It had been an excruciating week. With the continued market jitters over Fannie and Freddie—the result of Lehman’s own analyst’s report, no less—investors were also taking it out on the firm. Fuld couldn’t understand it; Lehman had taken its lumps in its previous quarter and raised new capital. Its balance sheet, he thought, was in better shape than it had been in a long time, reflecting Lehman’s decision to deleverage its investments—that is, reduce the amount of debt it used to make those investments.

  To Fuld, it was the shorts who kept driving down the stock price, spreading false information about Lehman’s health. Fuld had been told by several people that the “whisper campaign” against the firm was emanating from one place: Goldman Sachs. It made Fuld sick. His son, Richie, worked at Goldman as a telecommunications banker.

  He decided the time had come to call Lloyd Blankfein personally.

  “You’re not going to like this conversation,” Fuld began. He said he had been hearing “a lot of noise” about Goldman’s spreading misinformation. “I don’t know that you’re not ordering this,” he said menacingly, as if trying to intimidate Blankfein into admitting it.

  Blankfein, offended that Fuld would even attempt to bully him, said he knew nothing about the rumors and ended the call.

  These conversations became almost daily occurrences. Days later, Fuld heard rumors that Credit Suisse was spreading rumors about Lehman. He jumped on the phone to Paul Calello, CEO of Credit Suisse’s investment bank. “I feel like I’m playing whack-a-mole,” Fuld told Calello.

  The constant stream of bad news was not only affecting Lehman’s stock but was hampering Fuld’s efforts to raise more capital. Skip McGee’s investment banking team had been reaching out to at least a dozen prospects—Royal Bank of Canada, HSBC, and General Electric among them—but was coming up empty. The only suitor with any real interest continued to be the Korea Development Bank’s Min Euoo Sung, and though many executives on the thirty-first floor still had doubts about him, Fuld had directed the bankers to keep working on the Koreans. Indeed, he was even thinking about taking a trip to Asia himself to see Min in person to try to seal a deal.

  Then it struck him: What about his old friend John Mack at Morgan Stanley, the second-largest investment bank in the country after Goldman Sachs? The firm had had an ugly second quarter, reporting a 57 percent decline in earnings from a year earlier, but it still had enough cash and buoyancy in its stock price to be able to make a deal.

  Fuld and Mack had come up on Wall Street together, with Mack joining Smith Barney’s training program in 1968 before moving to Morgan Stanley in 1972, when it had just 350 employees. Like Fuld, Mack had begun his career in bond sales and trading. And again like Fuld, he had quickly made a name for himself. He was an effective salesman and someone who could be both charming and physically intimidating. Mack would stride through the trading floor and, seeing a chance to make big profits, would yell, “There’s blood in the water, let’s go kill someone!” Coming across a trader reading the Wall Street Journal at 8:00 a.m., he was known for saying: “I see that again, and you’re fired.” But, again like Fuld, he was also fiercely loyal to his people, once physically barring entry to the trading floor by upper management when he was still a trader.

  Fuld called Morgan Stanley in New York and was transferred to Paris, where Mack was visiting with clients in the firm’s ornate headquarters, a former hotel on the rue de Monceau.

  After some mutual disparagement of the markets, the rumors, and the pressure on Fannie and Freddie, Fuld asked candidly: “Can’t we try to do something together?”

  Mack had suspected the reason for Fuld’s call, and while he didn’t believe there was much chance that he’d be interested in such a prospect, he was willing to hear Fuld out. There might at least be some assets that he would be interested in; he doubted he would want to buy the entire firm. Mack told him he would be flying back to New York on Friday and suggested they see each other on Saturday.

  Fuld, clearly anxious to set up the meeting, said, “We’ll come over to your offices.”

  “No, no, that makes no sense. What if someone sees you coming into the building?” Mack asked. “We’re not going to do that. Come to my house, we’ll all meet at my house.”

  A harried Hank Paulson walked into room 2128 of the Rayburn House Office Building and took his seat. Today’s House Financial Services Committee hearing was scheduled to discuss “financial market regulatory restructuring,” but it was really just about Fannie and Fredd
ie. Paulson also wanted to start laying the groundwork for obtaining authority from Congress to wind down these government-sponsored enterprises—if it became necessary, which he didn’t anticipate. Paulson had visited Barney Frank, the chairman of the hearing, earlier in the week and had been encouraged “to ask for what you need.” Frank had pledged to support him.

  Now, as Paulson appeared before the committee with Ben Bernanke beside him, he made his case: “We’re going to need broader emergency authorities to—for the resolution or wind-down of complex financial institutions that don’t have federal deposit insurance,” he explained. “But that’s where we need to get. That’s what we’ve got to drive toward.”

  Representative Dennis Moore, a Democrat from northeast Kansas, asked, “Do you still believe the GSEs pose a systemic risk to the economy?” Paulson replied: “I would say, Congressman, in today’s world I don’t think it is helpful to speculate about any financial institution and systemic risk. I’m dealing with the here and now.”

  But by the time the market closed that day, the “here and now” had grown even worse, with more than $3.5 billion in the combined market value of Fannie and Freddie wiped out. Concerns were mounting about Fannie’s and Freddie’s debts and the rocky state of the mortgage-backed securities that the agencies had guaranteed. The markets were testing Washington’s resolve. How much chaos would the government tolerate before it stepped in?

  Although Paulson hadn’t believed he would require in the immediate future the authorities that he had discussed that morning, the overall economic situation was beginning to become alarming. He called Josh Bolten at the White House to sound him out about pressing Congress for the authority he wanted; Bolten was encouraging. He also wanted Alan Greenspan’s advice, and after some confusion about tracking down Greenspan’s home phone number, Paulson and a half dozen staff members huddled over the Polycom on his desk to hear the former Fed chairman’s faint voice through the speaker.

  Rattling off reams of housing data, Greenspan described how he considered the crisis in the markets to be a once-in-a-hundred-year event and how the government might have to take some extraordinary measures to stabilize it. The former Fed chairman had long been a critic of Fannie and Freddie but now realized that they needed to be shored up. He did have one suggestion about the housing crisis, but it was a rhetorical flourish befitting his supply-and-demand mind-set: He suggested that there was too much housing supply and that the only real way to really fix the problem would be for the government buy up vacant homes and burn them.

  After the call, Paulson, with a laugh, told his staff: “That’s not a bad idea. But we’re not going to buy up all the housing supply and destroy it.”

  As Paulson took a seat in the small conference room next to his office to begin breakfast with Ben Bernanke, he was flushed and scarcely able to eat. “This is a real problem,” he said.

  The front page of the New York Times had reported that morning that senior administration officials were “considering a plan to have the government take over one or both of the companies and place them in a conservatorship if their problems worsen.”

  Someone had leaked the story about Fannie and Freddie.

  Paulson, guzzling a can of Diet Coke as his oatmeal grew cold, couldn’t fathom why a member of the administration would be so foolish as to disclose the plans they had been considering. Whoever it had been, the leak was bound to undermine confidence even further, and Paulson was furious.

  It had already been a long morning for Paulson, and it showed in his eyes. He had briefed the president in the Oval Office at 7:10 a.m.; had a conference call with Tim Geithner at 7:40 a.m.; checked in with Larry Fink of BlackRock to get his thoughts on what to do about Fannie and Freddie at 8:00 a.m.; and even squeezed in time to reach out to Dick Fuld five minutes later.

  Soon after the stock market opened, Treasury staffers Jim Wilkinson and Neel Kashkari barged into the room, interrupting Paulson and Bernanke’s breakfast to tell them that the stocks of both Fannie and Freddie were sinking like a stone, down about 22 percent, and suggesting that Paulson put out a statement to calm the markets. Just as he had feared, the story in the Times had created a panic, with nobody certain what the implications of the government getting involved with Fannie and Freddie could possibly mean. Investors were recalling Paulson’s decision to press for the $2-a-share deal for Bear Stearns and asking themselves, Would that be the model?

  Paulson agreed he needed to tamp down all the anxiety. By 10:30 a.m. Treasury issued a statement under Paulson’s name, stating: “Today our primary focus is supporting Fannie Mae and Freddie Mac in their current form as they carry out their important mission.” By using the phrase “in their current form,” Paulson was trying to send a signal that he had no plans to nationalize the companies, even though he knew he might ultimately have to seek the power to do so.

  Still miffed by the leak, Paulson walked over to the White House as President Bush was preparing to go over to the Department of Energy on Independence Avenue for a briefing on oil and the energy markets. “Can I ride over with you, sir?” Paulson asked, and on the short trip there briefed Bush on the Fannie and Freddie situation. Bush, who had been a critic of the GSEs for years, was supportive of Paulson’s plan. As the motorcade arrived at their destination, Paulson suggested that when the president spoke to the press that afternoon he needed to tread carefully, fearful of spooking the markets even more. “Emphasize how committed we are to the stability of these organizations,” Paulson told him.

  Although Freddie’s stock price would plunge as much as 51 percent that day, falling to as low as $3.89, and Fannie shares sank by as much as 49 percent, they managed to pare back their losses, with Freddie ending the session down only 3.1 percent and Fannie down 22 percent. Paulson, meanwhile, began calling congressional leaders to determine what it would take to get Treasury the authority to put capital into Fannie or Freddie or to backstop their debt.

  Just as the market closed, Paulson had a call with Sheila Bair, the chairwoman of the Federal Deposit Insurance Corporation, who shared further dismaying news of the intense pressures in the mortgage market: The FDIC was about to seize IndyMac Bancorp, a mortgage lender, marking the fifth FDIC-insured bank failure that year and the biggest since the savings and loan debacle.

  Recognizing that Fannie and Freddie could soon spin out of control, Paulson summoned his brain trust to his office at 4:15 p.m. and told them to get ready to work throughout the weekend on a way to stabilize the GSEs. His plan was simple: He wanted to ask for the authority to put money into Fannie and Freddie, in the hopes that he’d never actually have to use it.

  “I want,” he instructed, “to announce a plan before the Asian markets open Sunday night.”

  On Saturday morning, Fuld pulled up to John Mack’s Tudor mansion in Rye, New York. Despite the beautiful weather, he was tense about the upcoming meeting. God help me, he thought, if this leaks. He could already imagine the headlines.

  “Dick, good morning,” Mack said amiably as he greeted Fuld at the front door. Mack’s wife, Christy, stepped out to say hello as well.

  The Morgan Stanley management team had arrived and were socializing in Mack’s dining room. There was Walid Chammah and James Gorman, the firm’s co-presidents; Paul Taubman, the firm’s head of investment banking; and Mitch Petrick, head of corporate credit and principal investments. They had probably been strategizing for hours, Fuld thought.

  McDade showed up next, dressed in a golf shirt and khakis. McGee was running late.

  On a table in the den, Christy had put out plates of wraps that she had ordered from the local deli and said, “Everything is all set for you guys.” As the group took their seats on sofas around a coffee table, an awkward silence followed; no one knew exactly how to begin.

  Fuld looked at Mack as if to say, It’s your house, you start. Mack imperturbably glared back, You asked for the meeting. It’s your show.

  “Well, I’ll kick it off,” Fuld finally said. “I’
m not even sure why we’re here, but let’s give it a shot.”

  “Maybe there’s nothing to do,” Mack said in frustration as he noticed the discomfort around the room.

  “No, no, no,” Fuld hurriedly interjected. “We should talk.”

  Fuld began by discussing Neuberger Berman, Lehman’s asset-management business and one of its crown jewels, as an asset that he would be prepared to sell. He also suggested that Morgan might buy Lehman’s headquarters on Seventh Avenue—the same building that had been Morgan Stanley’s until Philip Purcell, the firm’s former CEO, sold it to Lehman after 9/11. The irony would be rich.

  “Well,” said Mack, not entirely sure what Fuld was proposing, “there are ways we can, you know, there are ways we can work together.” He wanted to segue the conversation to Lehman’s internal numbers, because even if nothing were going to come of the meeting, it would be helpful to Morgan Stanley to get at least a peek at what was going on inside the firm. The Morgan team began to throw out a barrage of questions: How are things marked? Were you able to sell them inside your marks? How much business has left the firm? McDade ended up doing more of the talking than his boss as he tried to answer them.

  McGee, whose driver had gotten lost, finally arrived in the middle of the meeting, and Fuld gave him an anxious glare.

  When Fuld’s cell phone started ringing, he excused himself and retreated to the kitchen, leaving the Morgan Stanley side perplexed: Was Lehman working on another deal at the same time?

  What they didn’t know was that the caller was Paulson, at his Treasury office, checking on Fuld and updating him on his plans to propose a bill about Fannie and Freddie. Fuld was happy to hear that Paulson was seeking to stabilize the GSEs—he knew such a measure could help him as well.